OCIE Issues Risk Alert Regarding Advisers and Principal and Agency Cross Trading (2024)

On September 4, 2019, the Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) released a new Risk Alert¹regarding principal trading and agency cross transactions under Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) and the various compliance issues the OCIE staff identified in the course of its examinations of investment advisers.

Section 206(3) and Rule 206(3)-2 at a Glance

Section 206(3) of the Advisers Act imposes specific requirements for principal and agency cross transactions. Under Section 206(3) an investment adviser is prohibited from, directly or indirectly, knowingly purchasing any security from or selling any security to a client (a “principal transaction”), unless the investment adviser, prior to the completion of the transaction, makes written disclosure to the client of the capacity in which it is acting and obtains the client’s consent to such transaction.² The SEC interprets Section 206(3) to require an investment adviser to satisfy these disclosure and consent requirements on a transaction-by-transaction basis (i.e., blanket disclosure and consent are not permitted).³

Section 206(3) further prohibits an investment adviser, directly or indirectly, from effecting a transaction for a client if it is acting as a broker on both sides of the transaction (an “agency cross transaction”), without disclosing to that client in writing prior to the completion of the sale or purchase the capacity in which the investment adviser is acting and obtaining the consent of said client to the sale or purchase. Advisers Act Rule 206(3)-2, however, provides an exemption permitting an investment adviser to execute agency cross transactions without separate disclosure and consent for each individual transaction if certain conditions are met. Specifically, Rule 206(3)-2 permits investment advisers to execute agency cross transactions only if, among other things: (i) the client has executed a written consent prospectively authorizing agency cross transactions after receiving full written disclosure of the conflicts involved and other information described in the rule; (ii) the investment adviser provides a written confirmation to the client at or before the completion of each trade providing, among other things, the source and amount of any remuneration it received; (iii) the investment adviser provides a written disclosure statement to the client, at least annually, with a summary of all agency cross trades during such period; and (iv) the written disclosure documents and confirmations required by the rule conspicuously disclose that the client’s consent may be revoked at any time.⁴

OCIE’s Findings

While the Risk Alert does not address all the weaknesses the OCIE staff identified, it sets forth the most frequent deficiencies found by the staff in connection with Section 206(3) and Rule 206(3)-2:

• Principal Trades. With respect to principal transactions, OCIE staff observed:
  • Firms failed to recognize times in which they were engaging in principal transactions and thus failed to make written disclosures to the individual clients involved in such transactions or obtain the required client consents.
  • Even where firms recognized they engaged in principal trades with clients, they nevertheless failed to meet all the requirements of Section 206(3), including failing to (1) obtain the requisite prior consent for each principal trade⁵ and (2) provide sufficient disclosure regarding the potential conflicts of interests and terms of the transaction.
• Principal Trades and Pooled Investment Vehicles. With respect to principal transactions between investment advisers and pooled investment vehicles, OCIE staff observed:
  • Firms effected trades between advisory clients and an affiliated pooled investment vehicle but failed to recognize that the firm’s significant ownership interest in the pooled investment vehicle would cause the transaction to be subject to the requirements of Section 206(3).⁶
  • Firms that effected trades between themselves and pooled investment vehicle clients failed to obtain effective consent from the pooled investment vehicle prior to the completion of the transaction.
• Agency Cross Transactions. With respect to agency cross transactions, OCIE staff observed:
  • Firms engaged in numerous agency cross transactions in reliance on Rule 206(3)-2 despite disclosing to clients that they would refrain from doing so.
  • In purported reliance on Rule 206(3)-2, firms engaged in agency cross transactions, but could produce documentation evincing that they had complied with the written consent, confirmation or disclosure requirements of the rule.
• Policies and Procedures. OCIE staff observed that firms failed to implement policies and procedures with respect to Section 206(3) despite engaging in principal trades and agency cross transactions, as well as instances where firms did not follow their existing policies and procedures relating to principal and agency cross transactions.⁷

Takeaways

Investment advisers should take this opportunity to:

• Review and update existing policies and procedures to ensure that they reasonably address principal trades and agency cross transactions and any obligations related thereto under Section 206(3).
• Provide training to existing investment, client service and compliance personnel to ensure they understand their obligations under Section 206(3) and the firm’s approach to compliance with these obligations.
• Review and update their documentation relating to disclosures and consent of such transactions to make certain that they are clearly written and provide sufficient disclosure

In addition, investment advisers to private funds should monitor possible transactions between such private funds or between a private fund and an individual advisory client (e.g., a managed account) and pay particular attention to the 25% beneficial ownership threshold that would trigger any such private fund or account to be an account of the adviser for purposes of Section 206(3). Situations such as these typically arise in the early stages of a private fund’s life cycle, when ownership by the adviser’s affiliates can represent a higher percentage than would generally be the case down the road or in the later stages of a private fund’s lifecycle for similar reasons. In a recent SEC settlement, the SEC found that where an adviser to a private fund is affiliated with the private fund’s general partner, the consent provided by the general partner may be insufficient due to what the SEC views as an inherent conflict of interest.⁸ For this reason it is common for a private fund’s investors to delegate the consent function a separate entity or committee. Nevertheless, where a private fund has established a committee or similar measure to evaluate potentially conflicted transactions involving the investment adviser, such committee itself must be independent and free from conflict.⁹

Advisers or private fund managers should contact a member of WilmerHale’s Investment ManagementPractice with any questions about the effectiveness of existing policies and procedures relating to Section 206(3) or the structure and documentation of the consent process for principal transactions or agency cross transactions.