Enforcement Actions Highlight SEC’s Focus on Cross Trades & Principal Transactions
On September 21, 2020, the U.S. Securities and Exchange Commission (SEC) announced settled charges against a registered investment adviser (Adviser), relating to dealer-interposed cross trading between its client accounts and engaging in principal transactions with clients without the required disclosures and consent, in violation of various provisions of the Investment Advisers Act of 1940 (Advisers Act) and the Investment Company Act of 1940 (1940 Act).1 This enforcement action should serve as a reminder that the SEC will bring actions based upon trading activity that may not appear to involve a cross trade, but in substance, effectively results in a cross trade between client accounts.The Prohibited Cross Trades and Principal Transactions
From July 2014 through September 2016, on multiple occasions, the Adviser sold a security to an independent broker-dealer on behalf of a client account, and simultaneously purchased the same security from that broker-dealer for a different client account. The purchasing account always paid a markup over the price at which the other account had sold. These trades, which were all prearranged with the independent broker-dealer, occurred among various client types, including registered investment companies (RICs), private funds, collateralized loan obligation vehicles, and separate managed accounts of institutions and high net worth individuals. There were a total of 351 sell/purchase trades, 13 of which were principal transactions.2 The Adviser engaged in these trades when an account needed to sell a security that the Adviser believed was a good investment and wished to hold that investment in another account that it managed. The Adviser took the position that these trades saved its clients market and transaction costs. Although the trades were often referred to as cross trades in communications with broker-dealers, the Adviser did not believe that a trade needed to comply with Rule 17a-7 under the 1940 Act when a RIC was a party to the trade.3 As a result, the trades involving RICs were not affected in accordance with the RIC’s 17a-7 procedures or in compliance with Rule 17a-7, which provides a process for the pricing of the securities involved, prohibits payment of transaction costs, and requires board reporting and recordkeeping. Principal transactions involving an investment adviser and a fund are generally prohibited.4 Section 206(3) of the Advisers Act requires an investment adviser to disclose to its client in writing, prior to the completion of a principal transaction with that client, the capacity in which the Adviser is acting, and to obtain client consent to the transaction. The Adviser failed to provide disclosure and consent.Takeaways
This enforcement action is the latest in a series of enforcement actions involving dealer-interposed cross trades directed by an investment adviser for its clients.8 These enforcement actions illustrate the SEC’s view that even interposing a dealer in a transaction involving two of an investment adviser’s clients will likely be viewed as a cross trade.9 Although cross trades may result in a good result for each client involved, they must be effected in accordance with the investment adviser’s (or RIC’s) cross trade or 17a-7 policy. Investment advisers should assess the risks posed by their trading activity and review their cross trade/17a-7 policies and procedures to ensure that they include the following:- Monitoring of trading activity with a view toward identifying trades on opposite sides with the same dealer or trades with unusually small spreads.
- If trades are communicated through electronic communications, review of traders’ communications should include reviewing communications with broker-dealers in connection with trades identified in the post-trade review with a view toward identifying pre-arranged trades.
- Adequate training of personnel to ensure that traders are aware that these types of trades are considered cross trades, even if a dealer is interposed, and to escalate the issue to the firm’s Chief Compliance Officer or Legal Department.
Conclusion
Investment advisers should review their trading practices and, if appropriate, adopt additional policies, or implement changes to their existing policies, enhance their monitoring of trading activity, and conduct additional training. The SEC has now brought a number of these types of cases and, given the conflicts of interest involved, we expect that this will continue to be an area of focus for the examination and enforcement staff. If you would like to discuss this enforcement action, the types of trading patterns that could result in indirect cross trades, or the elements of a robust cross trading/17a-7 policy, please contact the author of this Legal Insight or one of the Practus attorneys with whom you work.Article Footnotes
- In the Matter of Palmer Square Capital Management LLC, Advisers Act Rel. No. 5586 (Sept. 21, 2020), available at https://www.sec.gov/litigation/admin/2020/ia-5586.pdf.
- The Adviser had a controlling interest in certain private fund accounts as the result of the Adviser and its controlling persons owning more than 25% of the private fund. See Section 2(a)(9) of the 1940 Act. Thus, trades involving those accounts would be considered principal transactions.
- Normally, trades effected pursuant to Rule 17a-7 are priced in accordance with the RIC’s 17a-7 procedures and instructions on the movement of the securities between the client accounts are sent to each client’s custodian, without the inter-positioning of a broker-dealer.
- Rule 17a-9 under the 1940 Act permits an investment adviser to purchase a downgraded or ineligible security from a money market fund under certain conditions. In addition, the SEC has granted no-action relief to permit an investment adviser to a RIC to engage in principal trades with the RIC to reimburse or indemnify the RIC for losses arising out of a defaulted security. See, e.g., Liquid Green Trust, SEC No-Act (pub. avail. Dec. 19, 1991).
- The SEC has announced plans to propose amendments to Rule 17a-7 within the next 12 months. We expect that these amendments will encompass the pricing of fixed income instruments. Regulatory Flexibility Agenda, Securities Act Rel. No. 10769 (Apr. 1, 2020), 85 FR 52861, 52867 (Aug. 26, 2020).
- In settled administrative proceedings such as this, the parties neither admit nor deny the SEC’s findings in the settled order, except as to the SEC’s jurisdiction over them and the subject matter of the proceedings, which are admitted.
- It does not appear that the Adviser was charged with any substantive violations as a result of effecting cross trades not involving RICs. Even though the Adviser was charged with causing violations by the RICs, the RICs themselves were not charged in this proceeding.
- E.g., In the Matter of Western Asset Management Co., Rel. No. IC-30893 (Jan. 27, 2014), available at https://www.sec.gov/litigation/admin/2014/ia-3763.pdf; In the Matter of Hamlin Capital Management, LLC., Rel. No. IA-4983 (Aug. 10, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-4983.pdf; In the Matter of Putnam Investment Management, LLC. and Zachary Harrison, Rel. No. IC-33257 (Sep. 27, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-5050.pdf.
- It is possible that in certain instances repurchasing a security from a dealer for another client after it had sold that security to the dealer from another client’s account would not be viewed as a cross trade if the sale and purchase were not pre-arranged and the dealer takes market risk. However, it can be difficult to monitor whether a trade is pre-arranged, and it is unclear how long a dealer needs to hold a security before the dealer will be viewed as having taken sufficient market risk.
