On July 21, 2021, the Division of Examinations issued a new Risk Alert – Observations Regarding Fixed Income Principal and Cross Trades by Investment Advisers1 from an Examination Initiative. This is a follow-up to a Risk Alert issued in September 2019,2 which highlighted the most common compliance issues observed by the staff related to principal and agency cross trades under the Investment Advisers Act of 1940. The new Risk Alert specifically focuses on compliance issues discovered in examinations of advisers who engage in cross trades, principal trades or both in fixed income securities.
Following is a summary of the staff’s findings from its latest exams in these areas. If you have not re-reviewed your practices in a while and would like to talk through the requirements and the associated SEC staff expectations, please feel free to contact me at email@example.com or (949) 629-3928. The Risk Alert provides a great overview of what is expected of advisers however, each firm and compliance program is different. Therefore, discussing your firm’s practices, policies and procedures, disclosures and testing with an expert can provide another viewpoint for potential enhancements. The exam staff will certainly expect advisers to be compliant in these areas in the future, particularly after issuing two Risk Alerts on these important topics.
The staff observed the following issues as part of its examination reviews:
- Compliance Programs – over half of the deficiencies involved inadequate policies and procedures.
- Policies and procedures were inconsistent with the adviser’s practices, disclosure requirements or regulatory requirements (e.g., policies prohibited principal trades, cross trades or both when such trades were in fact executed; policies required advance written consent when no such consent was obtained; and policies required disclosures to clients participating in the transactions and such disclosures were not made in a timely manner).
- Policies and procedures lacked certain considerations or guidance to give personnel the full scope of information to comply with the applicable requirements (e.g., ERISA prohibitions on certain practices were not communicated; policies did not provide guidance on the appropriate prices to use for cross trades; and policies did not provide applicable best interest guidance).
- Policies and procedures were not effectively tested. For example, certain firms did not test their compliance policies against the firm’s trade blotter and therefore did not know that transactions that were prohibited had occurred.
- Conflicts of Interest – as we all have seen, the SEC has been very vocal about advisers ensuring that conflicts are adequately identified, disclosed and mitigated (remember – you can’t use the word “may” to describe a conflict that in fact exists). The staff in its exams observed situations where conflicts existed in these transactions that were not identified, disclosed, mitigated, or otherwise addressed by a firm’s compliance program.
- The staff observed situations where cross trades were not executed at independent market prices, which, in the staff’s view, resulted in certain clients receiving an unfair price for the securities.
- Fixed income transactions are subject to markups or other fees and in some cases the staff observed that these costs were not fully disclosed.
- Written Disclosures – over one third of the deficiencies related to deficient disclosures (omissions of relevant information; no conflicts disclosure; or lack of disclosures in other client documents).
There is actually very good news when it comes to the deficiencies described in the Risk Alert. All of the deficiencies are reminders of what is required and what the SEC staff expects when they review your firm’s principal and/or cross trade practices. Moreover, each of the deficiencies are all correctable but most importantly legal and compliance officers must understand the business and what the business is doing. Only then can you adequately develop and implement your policies and procedures, make appropriate disclosures, and monitor and test those practices.
About the Author
Karen A. Aspinall is a Financial Services Partner at Practus LLP. She brings a wealth of experience and a solutions-oriented approach to our legal team as an authority on regulatory compliance matters involving SEC, DOL, NFA and CFTC matters. Karen’s practical experience and pragmatic approach to problem solving are valuable for clients who are looking to navigate the complex and ever-changing regulatory landscape.
- The Risk Alert is available at: fixed-income-principal-and-cross-trades-risk-alert.pdf (sec.gov)
- The September 2019 Risk Alert is available at: OCIE Risk Alert – Principal and Agency Cross Trading.pdf (sec.gov)
Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.