On July 21, 2021, the SEC’s Division of Examinations (the “Division”) published a risk alert detailing observations from an examination initiative focused on investment advisors engaged in cross trades and/or principal trades involving fixed income securities (“FIX Initiative”). This risk alert supplements the staff’s observations made in a September 2019 Risk Alert by providing greater detail on certain compliance issues related to investment advisor practices concerning principal and cross trades. The Division intends for the risk alerts to be reviewed together to provide a comprehensive understanding of legal requirements and compliance issues and serve as a helpful resource regarding the Commission’s action and interpretive guidance applicable to this focus area.
You may access the Division’s recent risk alert here. You may access the Foreside blog on the September 2019 Risk Alert here.
The Difference between Principal Trades and Cross Trades
A “principal trade” occurs where an advisor arranges for a security to be purchased or sold to a client from its account (versus purchasing or selling in the secondary markets). A “cross trade” occurs when an advisor effects a trade between two or more of its advisory clients’ accounts but does not charge a fee for effecting the transaction; and an “agency cross trade” occurs when an advisor arranges for a trade to be executed between a client and another party (collectively “cross trades”). When an advisor arranges these types of transactions for clients, its fiduciary duty is implicated in addition to other legal obligations under the Advisers Act.
Staff Observations on Advisors’ Practices for Principal and Cross Trades
Nearly two-thirds of the 20 examined advisors received staff-issued deficiency letters, which addressed the staff’s observations regarding various topics. The vast majority of deficiencies were related to compliance program issues, conflicts of interest, and disclosures, as discussed below.
- Compliance programs
- Deficiencies observed included:
- policies and procedures that were inconsistent from actual practice, disclosures, and regulatory requirements;
- policies and procedures that lacked certain information, considerations, or guidance, which affected the examined advisors’ personnel’s ability to achieve compliance; and
- policies and procedures that were not effectively tested.
- Conflicts of interest
- Deficiencies observed included:
- conflicts of interest associated with cross trades were not identified and mitigated, disclosed, or otherwise addressed by advisors in their compliance programs.
- Written disclosures
- In addition to the disclosure issues discussed above, other deficiencies observed included:
- Form ADV omissions of certain relevant information related to cross trading activities; and
- The lack of disclosures in the advisors’ Part 2As, advisory agreements, and separate written client communications related to conflicts of interest associated with executing such trades.
Staff Observations on Improving Compliance
While the staff observed that the content and effectiveness of the examined advisors’ compliance programs varied, the following practices performed by the examined advisors appeared to be effective:
- Adopting and imposing compliance programs that:
- incorporate all applicable legal and regulatory requirements;
- clearly articulate activities covered by written policies and procedures;
- set standards that address the advisors’ expectations for each of these activities;
- include supervisory policies and procedures; and
- establish controls for following and documenting compliance with policies and procedures.
- Conducting testing for compliance with policies and procedures
- Placing certain conditions or restrictions on the execution of principal and/or cross trades within clients’ accounts
- Providing written disclosures in multiple documents to clients that are full and fair and inclusive of all material facts surrounding principal and cross trades (such as a description of the nature and significance of the conflicts of interest relative to impacted clients).
The Division intended for the Risk Alerts to highlight compliance issues observed from its fixed income examination initiative. It is meant to encourage firms to assess their supervisory, compliance, and/or other risk management systems related to these observations and make any appropriate changes to address and strengthen such systems as necessary. Foreside encourages investment advisors to review their practices, disclosures, and written policies and procedures regarding principal and cross trades in light of these communications distributed by the SEC.