The SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert describing failures by investment advisers to comply with regulatory requirements when engaging in principal and agency-cross transactions. OCIE found that many advisers did not even recognize that they were engaging in (1) a principal transaction by buying or selling to a client or (2) an agency cross transaction when the adviser is acting as a broker for other than the client.
Advisers Act Section 206(3) 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.
Two of the items mentioned related to private funds. 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).
Staff in the Division of Investment Management has stated its view that Section 206(3) does not apply to a transaction between a client account and a pooled investment vehicle of which the investment adviser and/or its controlling persons, in the aggregate, own 25% or less. If the adviser owns more than 25% of the fund, it’s likely considered to a “principal” of the adviser under 206(3)
Second, OCIE noted 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. The SEC has brought charges against an adviser to a pooled investment vehicle failed to obtain effective consent to principal trades because the review committee established by the adviser to approve the pricing of the trades in an attempt to satisfy the requirements of Section 206(3) was itself conflicted.
Sources:
- OCIE Risk Alert: Investment Adviser Principal and Agency Cross Trading Compliance Issues September 4, 2019
- Gardner Russo & Gardner, IM Staff NoAction Letter (June 7, 2006)
- Paradigm Capital Mgmt., Inc., Advisers Act Rel. No. 3857 (June 16, 2014)