On September 4, 2019, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert addressing the most common compliance issues it identified in examinations of investment advisers (“Advisers”) related to principal and agency cross transactions.

The Risk Alert follows on the Interpretation Regarding Standard of Conduct for Investment Advisers (the “Interpretation”) issued by the SEC on June 5, 2019.[1] Although the Interpretation stated that it did not create any “new legal obligations for advisers,” the Risk Alert cites to the Interpretation for the proposition that Advisers may need to do more than merely comply with the disclosure and consent provisions of the Investment Advisers Act of 1940 (“Advisers Act”) in order to ensure clients provide informed consent to principal and agency cross transactions. This position and the citation may well signal an increased focus in examinations as well as SEC Enforcement Division investigations on the specific disclosure and process followed by Advisers in obtaining consent coupled with a view that, in some instances, conflicts may not be capable of being addressed through disclosure or even consent.[2]

The Risk Alert otherwise serves as a reminder for Advisers of the SEC’s expectations in this area as a prelude to pursuing enforcement actions if they don’t see conduct changing across the industry. Advisers should take the Risk Alert, and its reliance on the Interpretation, as an opportunity to review their policies and procedures to ensure they are consistent with recent SEC guidance on the subject.

Principal and Agency Cross Transactions Under the Advisers Act

Section 206(3) makes it unlawful for a person meeting the definition of an “investment adviser” under the Advisers Act, including both registered and unregistered advisers, to sell or purchase any security to or from a client when acting as principal for the Adviser’s account unless the Adviser has disclosed in writing to the client the capacity in which the Adviser is acting and obtained the client’s consent—on a transaction-by-transaction basis[3]—prior to settlement of the transaction. The SEC has taken the view that transactions with entities “controlled” by an Adviser or its affiliates also constitute principal transactions.

Agency cross transactions are treated differently under the Advisers Act, despite sharing certain similarities with principal transactions. An agency cross transaction occurs when an Adviser, or any person controlling, controlled by, or under common control with such Adviser, acts as broker for a person who is not the Adviser’s client and effects a sale or purchase of a security for the account of a client. Advisers are similarly prohibited from engaging in agency cross transactions under Section 206(3) unless the Adviser provides disclosure and receives consent. However, blanket disclosure and consent is permissible under Rule 206(3)-2 if:

  1. the Adviser executes a written consent prospectively authorizing agency cross transactions after receiving full written disclosure of the conflicts involved and other information required by the Rule;
  2. the Adviser provides a written confirmation to the client at or before the completion of each transaction providing, among other things, the source and amount of any remuneration received;
  3. the Adviser provides a written disclosure statement, at least annually, with a summary of all agency cross transactions during the period and the total amount of remuneration received through agency cross transactions;
  4. the Adviser includes a conspicuous statement in the written disclosures required by the Rule that consent can be revoked at any time; and
  5. neither the Adviser or a person controlling, controlled by, or under common control with the Adviser recommended the transaction to both the seller and purchaser.

OCIE Risk Alert and Noted Deficiencies

In the Risk Alert, OCIE noted that compliance with the disclosure and consent provisions described above may not fully satisfy an Adviser’s fiduciary obligations with respect to a principal or agency cross transaction. As support for this proposition, OCIE cited language contained in the Interpretation. OCIE noted the following as examples of the most common deficiencies or weaknesses identified by its staff in connection with Section 206(3) and Rule 206(3)-2.

  • Section 206(3) requirements not followed. OCIE provided examples of Advisers not appearing to follow the specific requirements of Section 206(3):
    • Advisers purchased or sold securities from or to clients while acting as principal for their own account but failed to recognize the transactions were subject to Section 206(3).
    • Advisers recognized transactions were principal trades with a client but nonetheless failed to meet all the requirements of Section 206(3), such as: (i) obtaining appropriate prior client consent for each trade, or (ii) providing sufficient disclosure regarding the potential conflicts of interest and terms of the transaction.
    • Advisers obtained client consent after the completion of the transaction.
  • Principal trade issues related to pooled investment vehicles (“Funds”). OCIE provided examples of deficiencies in transactions between Advisers and Fund clients:
    • Trades between advisory clients and an affiliated Fund where the Advisers’ significant ownership interests in the pooled investment vehicle would cause the transaction to be subject to Section 206(3).
    • Trades between Advisers and Fund clients without effective consent from the Fund prior to completing the transactions.
  • Agency cross transactions. OCIE provided examples of practices raising compliance issues in connection with agency cross transactions:
    • Advisers disclosed to clients that they would not engage in agency cross transactions, but in fact engaged in numerous such transactions.
    • Advisers effected agency cross transactions in purported reliance on Rule 206(3)‑2, but could not produce documentation that they had complied with the Rule’s requirements.
  • Policies and procedures related to Section 206(3). OCIE noted that Advisers did not have policies and procedures relating to Section 206(3), even though the Advisers engaged in principal and agency cross transactions, or had failed to follow such policies and procedures.

Key Takeaways

As noted above, although the issue of principal and agency cross transactions has previously been addressed by the SEC on numerous occasions, this Risk Alert is notable in light of its reliance on the Interpretation as additional support for the proposition that Advisers must receive informed consent to principal and agency cross transactions. Further, the examples cited, which reference “appropriate” and “effective” consent and providing “sufficient disclosure,” highlight the issues posed to Advisers in light of the Interpretation.

Advisers should carefully review their disclosures with a focus on whether additional or more stringent requirements and procedures should be applied for retail clients. Given the Interpretation’s observation that some conflicts may be so complex or extensive that they cannot be adequately disclosed, the Risk Alert’s reference to the Interpretation raises questions whether similar concerns may apply in the context of principal and agency cross transactions, which are by definition conflicted.

[1] For more discussion of the Interpretation, please see our Alert Memorandum, “SEC Adopts Best Interest Standard for Broker-Dealers and Fiduciary Duty Guidance for Investment Advisers.”

[2] The Interpretation noted that some conflicts may be so complex or extensive that a client could not give sufficiently informed consent irrespective of an Adviser’s disclosure. In such circumstances, the Adviser must either eliminate the conflict or mitigate the conflict such that full and fair disclosure is possible. See Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248, p. 28 (June 5, 2019).

[3] Section 206(3) requires disclosure and consent be provided for each transaction, such that blanket disclosure and consent are not sufficient.