SEC Principal and Agency Transactions Rule Re-Interpreted

Department of Labor May Authorize Cross Trades

July 27, 1998

The Securities and Exchange Commission (the "SEC") has issued an interpretive release under Rule 206(3) of the Investment Advisers Act of 1940 (the "Advisers Act"), which permits investment advisers to engage in principal transactions and in agency cross transactions only under specified conditions. The new release:

• permits investment advisers to make required disclosures and obtain client consent after execution but before settlement of a principal or agency transaction (rather than before execution), and
• explains that Section 206(3) does not apply to an agency transaction if an investment adviser receives no compensation for effecting such a transaction between advisory clients.

In a related development, the U.S. Department of Labor has announced that it is considering whether to exempt ERISA accounts from the existing prohibition against cross trades.

Background

Section 206(3) of the Advisers Act was intended to stem abuses that could arise when an adviser engages in principal or agency cross transactions with its clients. In a principal transaction, an adviser, acting for its own account buys a security from, or sells a security to, a client account. In an agency cross transaction, an adviser arranges a transaction between different clients or between a brokerage customer and an advisory client. Cross transactions can be further categorized as direct (when an investment adviser purchasers and sells a particular security between two or more accounts under its management without using a broker or going into the open market) and brokered (when an investment adviser places simultaneous purchase and sale orders of the same security with a broker-dealer). Generally, the objective of all of these types of transactions is to obtain more favorable prices for the securities being purchased or sold and, in the case of direct cross trades, avoid brokerage commissions. These transactions can also avoid adverse market impact, especially for less-liquid securities. Principal and agency cross transactions, however, also may pose the potential for advisers to engage in self-dealing. Principal transactions may lead to abuses such as price manipulation or the “dumping” of unwanted securities into client accounts. In an agency cross transaction, the incentive for certain advisers affiliated with broker dealers to earn additional compensation may create a conflict of interest. Section 206(3) provides in pertinent part that,

it shall be unlawful for any investment adviser, . . . acting as principal for his own account, knowingly to sell any security to or purchase any security from a client or acting as broker for a person other than [its] client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.

SEC Rule 206(3)-2 provides that an investment adviser registered under the Advisers Act or a person registered as a broker-dealer under Section 15 of the Securities Exchange Act of 1934 is only in compliance with the provisions of Section 206(3) in effecting such transactions for an advisory client if, among other requirements, the client has executed a written consent that is obtained before the completion of the transaction that the investment adviser will receive commissions from or otherwise have a conflict of interest regarding the parties to such transactions.

In a 1994 release, the SEC took the position that “before the completion of such transaction” meant before the transaction was executed. As one might imagine, advisers found it difficult to satisfy their disclosure obligations under Section 206(3) prior to the execution of a transaction because of the practical difficulties of contacting clients within a relatively short time and the risk that the market would move during the time it took to obtain the consent.

The SEC’s Revised Interpretation

The most controversial proposal in the MOU was the proposal that the NASAA develop an exam to test the subject matter knowledge and competency of state-registered investment adviser representatives. The NASAA has proposed to seek to have state regulators implement and require the passage of an exam as a requirement of being licensed as an investment adviser representative. States currently rely on the Series 65 exam to test investment advisor representatives. The NASAA proposal would revise the Series 65 exam to reflect recent state law changes resulting from the NSMIA and to insure that the exam will mandate a minimum degree of competency for investment advisor representatives.

The NASAA competency exam initiative is being supported by the Institute of Certified Financial Planners but has been criticize by the Investment Company Institute (the “ICI”). The ICI’s main criticism of the proposed exam is that a single “one-size fits all examination” will not adequately assess a person’s competency as an investment advisor representative given the broad definition of an investment advisor representative and the diverse functions which may be performed by an investment advisor representative. Additionally, the ICI does not feel that there is a demonstrated need for such an examination. Despite this criticism, it is expected that the NASAA will continue its initiative on the proposed investment advisor representative examination over the next several months.

ERISA Accounts

The U.S. Department of Labor (“DoL”) is considering whether to begin drafting a class exemption from its prohibited transactions rules for securities cross transactions by retirement plan investment managers or to hold a public hearing first to gain input from interested parties. As noted above, cross transactions present obvious fiduciary conflicts of interest. When one of the client accounts involved is subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), the investment manager is in the position of representing both a retirement plan and another, adverse party, one buying and the other selling. Under ERISA, a fiduciary is charged with the duty of acting for the exclusive benefit of retirement plan participants and beneficiaries. As a consequence, cross transactions involving ERISA plans are prohibited.

Writers responding to the DoL’s March, 1998 request for comments agreed that ERISA plans would benefit greatly from the cost reductions available in cross transactions, especially from the elimination of some brokerage commissions on equity securities and dealer margins on debt instruments. For example, David G. Tittsworth, executive director of the Investment Counsel Association of America, stated that, “pension plans are incurring costs and missing opportunities for increased incremental returns that otherwise would be available to provide well-

funded and secure retirement benefits for America’s workers” because of the DoL’s prohibition on cross-trading, and that, “[i]n effect, the cross-transactions prohibition is a constraint on the efficient deployment of a pension fund’s capital.” The Securities Industry Association maintains that, “[i]nvestment managers are placed in the anomalous position of having to forego transactions that they believe would be in the best interests of a plan in order to avoid violating existing Department interpretations.”

The DoL has indicated that it will look at, among other things, SEC Rule 17a-7 as a possible framework for relief from the prohibition. Rule 17a-7 permits cross trading between affiliated investment companies despite the prohibition contained in Sections 17(a) of the Investment Company Act of 1940 on transactions between an investment company and its investment adviser or its adviser’s affiliates. Among other things, Rule 17a-7 requires that:

• the transaction be carried out at the independent current market price of the security; consistent with the investment objective and policies of the affected mutual funds;
• no brokerage or transaction fees other than customary transfer fees be paid; and
• the mutual fund’s board of directors adopt and monitor procedures, on a quarterly basis, to ensure that Rule 17a-7 is followed.

Rule 17a-7 also details how an investment manager should determine the current price of the cross traded security, which for reported securities is either the last sale price or the average of the highest current independent bid and lowest current independent offer. Compliance with Rule 206(3)-2 under the Advisers Act is, of course, also required.

The adoption of a class exemption is not assured. The director of exemption determinations for the Pension and Welfare Benefits Administration, a DoL agency, has expressed an inclination to favor the prevention of potential abuse over an ability to pursue advisers who break the law.

To learn more about cross transactions or to discuss other issues relating to hedge funds and their investment managers, contact Howard A. Neuman or Steven B. Katz at (212) 818-9200 .