On September 4, 2019, the Office of Compliance Inspections and Examinations (“OCIE”) released a Risk Alert (the “Alert”) on the results of examinations of investment advisers where issues regarding principal and agency cross transactions were discovered. The Alert described common deficiencies found generally, and at private fund firms, specifically. The findings discussed come from examinations of registered investment advisers over the past three years.
Common principal transaction deficiencies found included:
- Entering into principal transactions while not following the requirements under Section 206(3), such as written disclosures and prior client consent;
- Failure to disclose the potential conflicts of interest and terms of the transaction to clients involved in the principal transaction; and
- Receiving client consent after the transactions was executed.
Some principal transaction findings were specific to private funds, and those included:
- Advisers failing to review ownership interests when engaging in transactions between advisory clients and affiliated pooled investment vehicles; and
- Failure to obtain effective consent from the private fund prior to the transaction due to inherent conflicts within the consent process.
Agency cross transactions were also addressed in the Alert. Some findings included:
- Disclosures by advisers stating their firm would not engage in agency cross transactions while the firm regularly employed Rule 206(3)-2 to conduct such transactions; and
- Lack of firm documentation to support compliance with Rule 206(3)-2, such as evidence of client consent, client confirmation, or disclosure requirements.
In addition, examinations found advisers failed to maintain written policies and procedures for Section 206(3) transactions or had policies that were not implemented while the firm engaged in either principal or agency cross transactions.
It can be difficult for firms to effectively identify principal transactions, especially in the private fund arena where the crucial determination lies within common ownership percentages of the affiliated entities involved.
Listed here are some key reference materials for advisory firms to review before engaging in either principal or agency cross transactions:
- Commission Interpretation of Section 206(3), Investment Advisers Act Rel. No. 1732 (July 17, 1998)
- Letter from Office of Chief Counsel, Division of Investment Management, SEC to Subcommittee on Private Investment Entities, American Bar Association (December 8, 2005), private funds
- Gardner Russo & Gardner, IM Staff No-Action Letter (June 7, 2006), private funds
- In the Matter of Gintel Asset Management, Investment Advisers Act Rel. No. 2079 (November 8, 2002)
- SEC v. Beacon Hill Asset Management, LLC, Litigation Rel. No. 18950 (October 28, 2004)
- Paradigm Capital Management, Inc., Investment Advisers Act Rel. No. 3857 (June 15, 2014)