In a risk alert published earlier this month, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) flagged investment advisers’ failure to adhere to requirements on disclosure and consent as issues compliance departments should examine.
The Investment Advisers Act of 1940 requires advisers to disclose and obtain consent of clients in so-called principal trades in which the investment adviser, acting as principal for his or her own account, sells or purchases any security from a client. In a similar vein, disclosure and prior consent are also required for agency cross trades when an adviser acts as a broker for someone other than the advisory client.
The premise of the rule does not seem all that complicated on its face. So why are investment advisers challenged to comply with these requirements to the extent that OCIE felt the need to issue a risk alert?
Some nuanced definitions
In actuality, “it appears that many of the difficulties advisers have in complying … is failing to recognize when certain accounts (like a fund managed by the adviser) constitutes a principal transaction,” explained Scott Moss, a partner at the law firm Lowenstein Sandler. The OCIE risk alert reports not only did advisers fail to identify principal trades correctly, even those who did still did not meet all the law’s requirements for obtaining prior consent or for disclosing potential conflicts of interest. Also, some advisers did not obtain client consent until a transaction had been completed.
Indeed, the definition of a “principal transaction” that would trigger the disclosure and consent requirements is not as clear-cut as, perhaps, the regulated community would like it to be. While the SEC did shed some light on the parameters of impacted transactions back in the 2006 Gardner Russo no-action letter, it did so in a couple of single-spaced pages and plenty of endnotes.
While “the Gardner Russo no-action letter provides useful guidance,” Moss observed, “not every instance where an account constitutes a principal account is obvious.”
The hassle with getting consent
The need-for-speed realities of a trade might also be impacting compliance with the consent requirements of the Advisers Act. “The transaction by transaction pre-trade consent required for principal transactions can also be impractical in certain cases,” Moss said.
“With respect to obtaining consent, most of the agency cross-transaction compliance issues I’ve seen relate to one of two things: timing or lack of communication,” said Daniel McAvoy, a partner at law firm Nixon Peabody. “Timing tends to be more of an issue with smaller firms that do not have large, built-out compliance departments,” he said.
Getting consent can sometimes be problematic. “An interesting point is that consent is required prior to settlement of a principal transaction rather than prior to execution of the transaction,” McAvoy explained. “Since many firms need to move quickly, there may be a presumption that the firm will be able to get the consent of its clients.”
But that anticipated consent is not necessarily forthcoming. People might be on vacation, or a client might actually decline to give consent because of the conflict, McAvoy said.
Beware affiliate links
The OCIE’s risk alert also indicated advisers did not always recognize trades between advisory clients and an affiliated pooled investment vehicle might also give rise to the disclosure and consent requirements. “Sometimes affiliations are hard to figure out,” explained Kelley Howes, counsel at Morrison Foerster. That lack of awareness can occur “because the level at which affiliation arises is low enough that some advisers maybe come up in a different business and don’t recognize it as affiliation.”
Compounding the problem can be the existence of a compliance infrastructure that has more of a back-end focus: It might identify a lack of compliance only after a requirement has already been violated. “It should be ahead of the transaction,” Howes said.
What to do?
To help identify affiliations, Howes suggested creating a checklist that is part of the process. It might not include all of the requirements to be deemed an affiliate, but it should be enough to trigger a call to a compliance officer to walk through the determination.
The OCIE suggested affected organizations review their policies and procedures to ensure compliance with the principal trading and agency cross-transaction provisions of the Advisers Act. Interestingly, “many larger organizations don’t necessarily have policies and procedures that are completely harmonized,” McAvoy observed. “I know of firms with multiple verticals where the policies and procedures for an adviser operating under one strategy are completely different than another affiliated adviser operating under a different strategy.”
Clearly, some measure of harmonization of policies and procedures may be necessary. “It is key to ensure that each advisory segment and broker-dealer within the firm communicate with each other and have policies that work together to prevent unwitting violations,” McAvoy said.
“One way pertinent policies and procedures can be revised is by maintaining an updated list of principal accounts and requiring pre-approval by the CCO (or his or her designee) of any proposed trades between an advisory client and an account on that list,” Moss suggested. That way, the CCO or the designee can track the need for and collection of a client’s consent. “Computer systems can also be programmed to flag any such trades prior to execution,” Moss noted.
Training refreshers when the SEC issues a risk alert highlighting an issue “are always a good idea,” Moss said.
Lori Tripoli is a writer based in the greater New York City area who focuses on legal and regulatory issues.