Latest SEC observations on fixed income principal and cross trades
Background on SEC cross trades risk alert
In July 2021, the SEC’s Division of Examinations issued a risk alert on cross trades and principal transactions. In the risk alert the SEC provided additional guidance, suggestions and cautions to all registered advisers. The SEC also encouraged advisers to review their written policies and procedures regarding principal or cross trades, including their implementation, under the Advisers Act. The risk alert’s guidance and warnings were based on over 20 examinations of investment advisers that engaged in cross trades or principal transactions involving fixed income instruments. The SEC recorded that nearly two-thirds of the advisers examined received deficiency letters and the vast majority of deficiencies related to compliance programmes, conflicts of interest and inadequate disclosures.
This follows the SEC’s earlier 2019 risk alert, which focused on common cross trade and principal transaction deficiencies observed in examinations conducted over a three-year period. The SEC stated that investment advisers were strongly advised to be well prepared prior to entering into principal or agency cross trades and warned that several investment advisers had received significant financial penalties for noncompliance in recent years.
How to ensure cross trades are handled appropriately
In order to ensure that principal and agency cross trades are handled appropriately, investment advisers should be familiar with Section 206(3) of the Advisers Act and consult with legal or compliance advisers where necessary. There are a number of rules that must be complied with and it is important that investment advisers keep documented policies and procedures that address the approach to be taken when a principal or agency cross trade is anticipated.
A widespread approach to assisting with compliance with Section 206(3) would be to set up a ‘conflicts committee’. This committee would be tasked with overseeing any principal or agency cross trades to ensure that the investment adviser’s policies and procedures are being correctly followed, to ensure that any trades are appropriately disclosed and to ensure that any trades are fair to all parties involved.
In many cases, however, investment advisers are unable to, or fail to, set up conflicts committees that provide sufficient independence to enable effective consent. In the SEC’s case against Paradigm Capital Management, Inc. (“Paradigm”), the conflicts committee was comprised of Paradigm’s CFO and CCO, and subsequently Paradigm’s hedge fund entered into principal trades with its broker-dealer, a related party by virtue of common ownership which shared the same CFO. Due to the lack of independence of Paradigm’s conflicts committee, the SEC ruled that the principal trades violated Section 206(3). Consequently, Paradigm was ordered to repay US $1.7m plus interest to investors and pay a US $300,000 civil penalty.
How can Waystone help?
Waystone has extensive experience assisting investment advisers and their funds by providing independent oversight from a talented pool of professional directors serving on the boards of many of the largest and most successful US-advised hedge, private equity, venture capital and real estate funds. Building on this experience, Waystone has a team of knowledgeable professionals serving on conflicts committees, providing independent oversight of principal and agency cross trades.
We would be happy to discuss this further with you and your legal or compliance advisers to determine how we can help provide independence and effectiveness to your compliance programs and conflicts committees. Please reach out to your usual Waystone representative.