Continuing the practice of issuing Risk Alerts summarizing examination findings, which has only increased under the leadership of the now departing Division of Examinations (EXAMS) Director Pete Driscoll, on 21 July 2021, EXAMS issued such an Alert on fixed income principal and cross trades by investment advisers, a topic that the SEC Staff has been scrutinizing for some time.

The Risk Alert considers the Staff’s “observations” from more than 20 examinations that were part of an exam initiative focused on investment advisers that engaged in “principal trades” (purchase/sale transactions with a client from the adviser’s own account); “agency cross trades” (transactions executed between a client and another party); and “cross trades” (transactions executed between the advisers’ clients). Previously, in September 2019, EXAMS had issued a Risk Alert on “Investment Adviser Principal and Agency Cross Trading Compliance Issues,” to which this newer Alert serves as a follow up.

The initiative, or exam sweep, focused on conflicts of interest; compliance programs, including policies and procedures; and disclosures. When it was over, the EXAMS Staff had issued deficiency letters in two-thirds of the examinations. Half of the noted deficiencies related to firms’ policies and procedures; among the issues identified:

  • failure to conform policies and procedures to the firm’s actual practices and/or to regulatory requirements;
  • lack of specifics, such that compliance could not be defined or achieved; by way of example,
    • no measures to determine how a transaction is actually in a client’s best interest and no required documentation to memorialize that analysis;
    • no process to value trades where the required multiple quotes differed; and
    • no effective testing of policies and procedures.

EXAMS also identified conflicts of interest and deficiencies in written disclosures. These conflicts, like the failure to execute at independent market prices or to use best execution efforts, were not picked up or mitigated by the firms’ compliance programs.  Disclosure deficiencies comprised fully one-third of those cited and included the complete failure to disclose the conflicts of interest associated with engaging in these types of transactions, as well as the omission of particular relevant facts about these types of trades.

The Risk Alert identifies some best practices that might seem obvious, but bear repeating:

  • Review and update your compliance policies and procedures.
    • Make sure your actual practices match your compliance program and your disclosures.
  • Establish controls and test your policies.
  • Set standards for these types of transactions, be specific, and comply with those standards.
  • Ensure that your disclosures are full and complete, identifying all conflicts of interest.
    • Provide these disclosures in all relevant client-facing documents.
  • Document your process for determining price and for best execution.

We can anticipate that EXAMS will continue to review for these issues, given the opacity of some parts of the fixed income market and the potential for conflicts of interest inherent in these transactions.  And, we can hope that even after Pete Driscoll departs, EXAMS will continue to tell us all what’s on its collective mind!

Author

Amy serves as the Co-Chair of Baker McKenzie's North America Financial Regulation & Enforcement Practice, which provides clients with a full range of regulatory advice and enforcement counseling. Amy also serves on the steering committees of the Firm's Global Financial Services Regulatory and Global Financial Institutions Groups.

Author

Jennifer serves as the Co-chair of Baker McKenzie's Financial Regulation and Enforcement Practice in North America. Jen is an experienced investment management lawyer with particular focus on investment adviser regulation and the convergence of investment advisory and brokerage services. She regularly represents clients before the US Securities and Exchange Commission (SEC), both in seeking interpretative guidance and in managing examination and enforcement matters. Jen is a leading practitioner in digital investment advice and the use of FinTech in the asset management industry.