Division of Examinations Cautions Advisers on Compliance Deficiencies with Fixed Income and Principal Cross Trades
On July 21, 2021, the SEC’s Division of Examinations issued a Risk Alert highlighting compliance deficiencies observed by the staff during an examination initiative focusing on investment advisers engaged in fixed income cross trades and principal trades—referred to by the staff as the “FIX Initiative.” The FIX Initiative involved over 20 examinations of advisers that collectively managed approximately $2 trillion in assets for over two million client accounts, including more than 1 million retail clients, nearly 3,000 pension and profit sharing plans and over 150 mutual funds. Focus areas for the SEC staff during the FIX Initiative included: (1) conflicts of interest; (2) compliance programs; and (3) disclosures.
The deficiencies observed by the SEC staff included the following:
Policies and procedures were inconsistent with adviser practices, disclosures and/or regulatory requirements. For instance, the SEC staff noted compliance programs that did not include specific procedures to confirm whether principal trades, cross trades or both were completed in a manner consistent with the advisers’ disclosures to clients and their policies and procedures, or whether appropriate consent was received from, and disclosure provided to, the involved clients prior to completing the transactions.
Policies and procedures lacked certain considerations or guidance, such that the examined advisers’ personnel did not have the full scope of information that may be necessary to achieve compliance. For example, the SEC staff observed advisers that did not specify in their procedures the factors advisory personnel should consider in seeking to determine that trades were in the best interests of clients, as well as advisers that did not include a section in their cross trading reporting forms to document why trades were considered to be in the best interests of the participating clients.
Policies and procedures were not effectively tested.Many examined advisers did not effectively test the implementation of their written compliance policies and procedures for principal and cross trades, such as by analyzing their trade blotters to identify unreported principal and cross trades.Consequently, the SEC staff observed that advisers, including firms that prohibited cross trades, were unaware that these trades had occurred.
Unidentified or unaddressed conflicts of interest. For example, the SEC staff noted cross trades that were subject to markups or other fees that were not fully disclosed. In other instances, the SEC staff noted cross trades that were not executed at independent market prices and did not use best price and best execution efforts, resulting in participating clients receiving an unfair price for the securities.
Written disclosure deficiencies. For example, the SEC staff noted that advisers omitted certain relevant information concerning cross trading activities in their Forms ADV or had no disclosures regarding the conflicts of interest associated with executing such trades in Part 2A of their Forms ADV.
In addition to the foregoing deficiencies, the Risk Alert includes the staff’s observations as to certain industry practices that may help firms address some of the areas of noncompliance.
The Risk Alert encourages advisers to review their written policies and procedures regarding principal and cross trades, including the implementation of those policies and procedures, to ensure that they are consistent with regulatory requirements.
The Risk Alert is available here.