SEC Enforcement Action Involving Unlawful Cross Trades & Principal Transactions

Steve KingLegal Insights

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By Financial Services Partner, Steve King

Enforcement Actions Highlight SEC’s Focus on Cross Trades & Principal Transactions

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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.


PRACTUS NOTE: Investment advisers that manage fixed income assets are more likely to encounter dealer-interposed cross trade issues because many fixed income instruments are less liquid, trade in more opaque markets, and may be difficult or impossible to price under a RIC’s Rule 17a-7 procedures (or, for non-RICs, the investment adviser’s cross trade policy). 
As a result, a trader may seek to sell the security to a dealer and repurchase the security from the same dealer believing that such trades do not constitute “cross trades.”  Securities that trade on an exchange or a platform with more liquidity than the over the counter market are less likely to be “crossed” in this manner.5

Deficiencies in the Adviser’s Compliance Policies and Procedures

The Adviser’s compliance manual permitted cross trades “when permitted,” but did not otherwise specify the circumstances under which cross trades could be effected.  Its compliance manual prohibited principal transactions.  However, the Adviser did not monitor trading activity to identify potential cross trades or principal transactions and did not conduct any training of its personnel regarding the circumstances under which cross trades were permitted or on the prohibition of principal transactions. 

The compliance policies of the RICs permitted cross trades conducted in conformity with Rule 17a-7; however, because the Adviser did not believe that the trades at issue were cross trades, the Rule 17a-7 policies were not followed.

Violations

The SEC found6 that, as a result of the principal transactions between the Adviser and its clients, the Adviser willfully violated Section 206(3) of the Advisers Act, and as a result of the cross trades between certain of its clients and the RICs, it caused those clients to violate Sections 17(a)(1) and 17(a)(2) of the 1940 Act.  The SEC also found that as a result of its inadequate compliance policies and procedures, the Adviser willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder and caused the RICs to violate Rule 38a-1 under the 1940 Act.7  

Sanctions

The Adviser was censured, ordered to cease and desist from committing or causing any violations and any future violations of Sections 17(a)(1) and 17(a)(2) of the 1940 Act and Rule 38a-1 thereunder, and  Sections 206(3) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, and was required to pay a civil money penalty of $450,000.


PRACTUS NOTE: Although this case was brought by the SEC and involved violations of the Advisers Act and the 1940 Act, if either of the clients was a benefit plan investor, the same trades may have constituted violations of the Employee Retirement Security Income Act of 1974 (ERISA), which is enforced by the Department of Labor.  This increases the potential harm resulting from a failure to prevent such trades from occurring.

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.  

About the Author

Steve King Practus Partner

Practus Partner and Financial Services attorney, Steve King, has provided legal advice on SEC regulations and investment management for over 20 years.
Steve specializes in a wide array of regulatory and compliance issues that arise under the federal securities and commodities laws, including assisting in regulatory examinations, advising on the use of derivatives by registered investment companies, cross-trading, trade allocation policies, trade error policies, and affiliated transactions.  
 
Attorney Phone Email
Steve King (949) 245-2700 Stephen.King@Practus.com

 

Article Footnotes


  1.  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.
  2. 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.
  3.  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.
  4.  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).
  5.  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).
  6.  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.
  7.  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.
  8.  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.
  9.  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.