Compliance Solutions for Investment Advisers

FAQs — Principal & Agency Cross Transactions

 

Principal Transactions

What is a principal transaction?

In a principal transaction, an adviser, acting for its own account, buys a security from, or sells a security to, the account of a client. A principal transaction also includes a situation where an affiliate or controlling person of an investment adviser engages in a trade with an advisory client.

What regulatory issues should an investment adviser be concerned with when engaging in a principal transaction?

A principal transaction creates the potential for advisers to engage in self-dealing. Principal transactions may lead to abuses such as price manipulation or the placing of unwanted securities into client accounts (a practice known as dumping).

What are the requirements for engaging in a principal transaction?

Section 206(3) of the Advisers Act makes it unlawful for any investment adviser, directly or indirectly acting as principal for its own account, knowingly to sell any security to or purchase any security from a client without disclosing to such client in writing before the completion of such transaction the capacity in which the adviser is acting and obtaining the consent of the client to such transaction.

What are an investment adviser’s disclosure requirements when engaging in a principal transaction?

An adviser must disclose all facts necessary to alert the client to the adviser’s potential conflicts of interest in a principal transaction.  Pursuant to Rule 206(3)-3T under the Advisers Act, written disclosure must be provided to the advisory client explaining:

  • The circumstances under which the investment adviser directly or indirectly may engage in principal transactions;
  • The nature and significance of conflicts with its client’s interests as a result of the transactions; and
  • How the investment adviser addresses those conflicts.

Are there any other disclosure requirements for a principal transaction?

Each written disclosure must include a conspicuous, plain English statement that the client may revoke the written consent without penalty at any time by written notice to the adviser.

What is the consent requirement for a principal transaction?

The advisory client must execute a written, revocable consent prospectively authorizing the investment adviser directly or indirectly to act as principal for its own account in selling any security to or purchasing any security from the advisory client.

What is the timing of the disclosure and consent requirements?

An investment adviser, prior to the execution of each principal transaction must:

  • Inform the advisory client, orally or in writing, of the capacity in which the adviser may act with respect to such transaction; and
  • Obtain consent from the advisory client, orally or in writing, to act as principal for its own account with respect to such transaction.

Can an investment adviser obtain a blanket consent for all principal transactions?

No. Notification must be provided and consent must be obtained separately for each principal transaction.

Is an investment adviser required to send confirmation of the principal transaction to the client?

An adviser must send a written confirmation at or before completion of each such transaction that includes, in addition to the information required by the Securities Exchange Act of 1934, a conspicuous, plain English statement informing the advisory client that the adviser:

  • Disclosed to the client prior to the execution of the transaction that the adviser may be acting in a principal capacity in connection with the transaction and the client authorized the transaction; and
  • Sold the security to, or bought the security from, the client for its own account.

When is a securities transaction completed?

Implicit in the phrase “before the completion of such transaction” is the recognition that a securities transaction involves various stages before it is “complete.” The phrase “completion of such transaction” on its face would appear to be the point at which all aspects of a securities transaction have come to an end. That ending point of a transaction is when the actual exchange of securities and payment occurs, which is known as “settlement.

Are there any annual disclosure requirements for principal transactions?

An investment adviser must send to the client, no less frequently than annually, written disclosure containing a list of all principal transactions that were executed in the client’s account, the date and the total amount of commissions or other remuneration received, or to be received, by the adviser or its affiliate in connection with the transactions.

Does an investment adviser still have a best execution responsibility when engaging in a principal transaction?

An adviser engaging in a principal transaction is not relieved in any way from acting in the best interests of an advisory client, including fulfilling the adviser’s duty with respect to the best price and execution for the particular transaction for the advisory client.

What types of records will the SEC request during or prior to an examination?

The Staff of the SEC may request some or all of the following documents and information pertaining to principal transactions:

  • A description of the process for obtaining the client’s approval for principal transactions (e.g., electronic delivery, etc.).
  • A description of the frequency of the review process for principal transactions.
  • A list of securities for which the adviser or any affiliate was a market maker during the examination period.

 

Agency Cross Transactions

What is an agency cross transaction?

An agency cross transaction is when the investment adviser arranges a trade between different advisory clients. The definition in Rule 206(3)-2 states that an agency cross transaction for an advisory client shall mean a transaction in which a person acts as an investment adviser in relation to a transaction in which such investment adviser, or any person controlling, controlled by, or under common control with such investment adviser, acts as broker for both such advisory client and for another person on the other side of the transaction.

What regulatory issues should an investment adviser be concerned with when engaging in an agency cross transaction?

One danger with agency cross transactions is that an advisory firm may favor one client to the detriment of another client. Another danger is the incentive to earn additional compensation that creates the adviser’s conflict of interest when effecting agency transactions between clients. For example, if one client pays performance fees and another does not, agency cross transactions might give the adviser the opportunity to earn additional compensation.

What are the requirements for engaging in an agency cross transaction?

Section 206(3) prohibits any adviser from engaging in or effecting an agency transaction with a client without disclosing in writing to the client, “before the completion of such transaction,” the capacity in which the adviser is acting and obtaining the client’s consent.

What are an investment adviser’s disclosure requirements for an agency cross transaction?

An adviser must make full written disclosure with respect to agency cross transactions that the adviser will act as broker for, receive commissions from, and have a potentially conflicting division of loyalties and responsibilities regarding, both parties to such transactions.

Are there any other disclosure requirements for an agency cross transaction?

Each written disclosure must include a conspicuous statement that the written consent may be revoked at any time by written notice to the adviser from the advisory client.

What is the consent requirement for an agency cross transaction?

The investment adviser must obtain from the advisory client a written consent prospectively authorizing the investment adviser to effect agency cross transactions for such advisory client.

What is the timing of the consent requirement?

Written consent may only be obtained after full written disclosure.

Is an investment adviser required to send confirmation of the agency cross transaction to the client?

The investment adviser must send to each such client a written confirmation that includes:

  • A statement of the nature of such transaction;
  • The date such transaction took place;
  • An offer to furnish upon request, the time when such transaction took place; and
  • The source and amount of any other remuneration received or to be received by the investment adviser in connection with the transaction.

Are there any annual disclosure requirements for an agency cross transaction?

An adviser must send to each client, at least annually, and with or as part of any written statement or summary of such account from the adviser, a written disclosure statement identifying the total number of such transactions during the period since the date of the last such statement or summary, and the total amount of all commissions or other remuneration received or to be received by the adviser in connection with such transactions during such period.

Does an investment adviser still have a best execution responsibility when engaging in an agency cross transaction?

An adviser engaging in an agency cross transaction is not relieved in any way from acting in the best interests of an advisory client, including fulfilling the adviser’s duty with respect to the best price and execution for the particular transaction for the advisory client.

What types of records will the SEC request during or prior to an examination?

The Staff of the SEC may request a list of cross transactions which took place during the examination period in which any current or former client and/or proprietary or affiliated account was a participant (include transactions where a broker was used or where the adviser, acting without a broker, effected the transactions).

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

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