Rebalancing and Other Cross Transactions

November 13, 2008

The Office of Chief Counsel of the Division of Investment Management of U.S. Securities and Exchange Commission (“SEC”) recently addressed an issue of particular interest to hedge fund managers—namely, to what extent must an agency cross transaction by an investment adviser be treated as a principal transaction under Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”).  That section permits investment advisers to engage in principal transactions and in agency cross transactions only under specified conditions.  In a no-action letter to Gardner Russo & Gardner, a registered investment advisory firm, publicly available on June 7, 2006, the staff of the SEC (the “Staff”) adopted the view that an agency cross transaction must be treated as a principal transaction if the investment adviser and/or its controlling person own in the aggregate in excess of a 25% ownership interest in one of the clients participating in the cross transaction.

BACKGROUND

Section 206(3) of the Advisers Act is intended to stem abuses that can arise when an investment adviser engages in principal or agency cross transactions with or for its clients.  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.

In a principal transaction, an investment adviser, acting for its own account, buys a security from, or sells a security to, a client account.  In an agency cross transaction, an investment adviser arranges a transaction between different clients or between a brokerage customer and an advisory client.  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 some cases to avoid brokerage commissions.  These transactions can also avoid adverse market impact, especially for less-liquid securities.  Principal and agency cross transactions, however, pose the potential for an investment adviser 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. 

SEC Rule 206(3)-2 provides that a registered investment adviser is in compliance with the provisions of Section 206(3) in effecting such transactions for an advisory client only if, among other requirements, the investment adviser has identified and explained the potential conflicts of interest arising from the adviser’s participation in a principal or agency cross transaction in sufficient detail to enable each client involved in such a transaction to make an informed decision on whether to grant its consent to the transaction before completion of the transaction.

Cross transactions are a common occurrence, especially in connection with rebalancing transactions when an investment adviser manages a number of client accounts designed to be balanced in portfolio composition. From time to time, primarily through the addition and withdrawal of investment capital and, in the case of private investment partnerships and other pooled investment vehicles (“hedge funds”), the addition and withdrawal of investors, some portfolios will deviate from the desired balance.  To compensate for these imbalances, an investment adviser may cause its clients to enter into cross transactions in which clients whose holdings of particular securities are too large will trade some of those securities to clients whose holdings of such securities are too small. 

In 1998, the SEC reversed a prior interpretation and announced that if an investment adviser receives no brokerage commission or other compensation (other than its advisory fee), directly or indirectly, for effecting a particular cross transaction between advisory clients, the investment adviser is not “acting as broker” within the meaning of Section 206(3), and is not be subject to its restrictions. [1] Typically, an investment adviser will not receive any compensation for effecting rebalancing cross transactions between advisory clients.  Thus, absent special circumstances, no prior consent is required in connection with rebalancing transactions. [2] Nevertheless, if an investment adviser, its affiliates or principals, [3] owns a substantial equity interest in a client such as a hedge fund, a cross transaction involving that client could be characterized as a principal transaction, indistinguishable from a direct transaction between the investment adviser and the other client accounts involved in the trade.  If so, full disclosure to and the prior consent of every client involved in the cross transaction would be required.  Before the Gardner Russo & Gardner no-action letter, the percentage of equity interest that would cause such a cross transaction to be characterized as a principal transaction was unknown.

RECENT DEVELOPMENTS

This issue appears to have first been raised publicly in a 2002 SEC administrative proceeding brought against a registered investment adviser, Gintel Asset Management, Inc., an affiliated broker-dealer and two key officers. [4] The SEC found that the investment advisory firm violated Section 206(3), and that Robert Gintel, the adviser’s sole owner, “aided and abetted and caused the adviser’s section 206(3) violations.” Among other things, Mr. Gintel directed cross transactions between a registered investment company in which he owned a 34% stake and other client accounts without disclosing the investment adviser’s capacity and obtaining the consents of the clients to such transactions as required by Section 206(3)-2.  By reason of Mr. Gintel’s 34% ownership interest, the SEC determined that all transactions involving the investment company were principal transactions.

In light of the Gintel Asset Management, Inc. proceeding and in anticipation of massive “hedge fund registration” pursuant to (now rejected) SEC Rule 203(b)(3)-2, [5] the American Bar Association’s Subcommittee on Private Investment Entities sought interpretive guidance in 2005 regarding among other things, the applicability of Section 206(3) to hedge fund rebalancing transactions. Given that hedge fund managers generally have significant ownership interests in at least some of the hedge funds they manage and frequently engage in rebalancing transactions, this issue had taken on considerable significance. However, in its response letter (publicly available December 8, 2005), the Staff merely stated that the applicability of Section 206(3) would depend on “all of the facts and circumstances of the transaction.” Nevertheless, the Staff invited investment advisers to submit specific factual information seeking interpretive guidance concerning the applicability of Section 206(3) to rebalancing and other transactions.

Gardner Russo & Gardner seemingly did just that.  Gardner Russo & Gardner had substantially smaller stakes in the clients about which they inquired than had Robert Gintel.  In their case, an affiliated company served as the general partner of two hedge fund clients and owned 6.237% and 1.4405% interests in the hedge funds, respectively. Gardner Russo & Gardner asked whether these small ownership percentages triggered Section 206(3) responsibilities.  The Staff stated not only that Gardner Russo & Gardner’s proposed transactions would not be subject to Section 206(3) but went on to state that Section 206(3) would only apply to a cross transaction in which the investment adviser and/or its controlling persons own, in the aggregate, more than 25% of a client account participating in the transactions. The letter further noted that even in situations when Section 206(3) does not apply (e.g., because aggregate ownership is 25% or less) the general anti-fraud provisions of Sections 206(1) and (2) of the Advisers Act would still require an investment adviser to disclose any potential conflict of interest.

The significance of the Gardner Russo & Gardner letter is the establishment of a bright-line test to guide investment advisers that may be considering rebalancing and other cross transactions for their clients.  Those clients in which they, together with their controlling persons, have ownership interests exceeding 25% must be excluded from such transactions or the investment adviser is required to satisfy the requirements of Section 206(3) prior to having those clients participate in those transactions.  The latter alternative may prove too cumbersome and impractical to be relied upon by many investment advisers. 

Other important issues remain, however.  In gauging whether a hedge fund client may or may not participate in re-balancing cross transactions, an investment adviser will need to determine whose holdings to include with its own when determining if the investment adviser and its controlling persons’ holdings of the hedge fund exceed 25%.  If the hedge fund’s general partner or equivalent managing entity is the investment adviser or an affiliate of the investment adviser, its holdings will undoubtedly need to be included.  Similarly, if either the investment adviser or an affiliated general partner is controlled by one individual, that person’s holdings, as well as those of his or her family members should be included.

The Gardner Russo & Gardner no-action letter states in a footnote that the Staff takes no position as to whether Section 206(3) applies to cross trades between client accounts when non-controlling personnel of an investment adviser have ownership interests in those accounts.  Thus, when measuring holdings in client accounts against the 25% standard, an investment adviser could, for example, include—with the investment adviser’s and any related general partner’s holdings—the personal holdings of (going from a very conservative approach to a less conservative approach):

• All of the investment adviser’s personnel;

• Only those employees that are engaged in securities analysis and trading; or

• Only the investment adviser’s and affiliated general partner’s significant equity owners.

Certainly, the more conservative approach an investment adviser adopts the less likely it will be that a cross transaction will be characterized as a principal transaction under Section 206(3) of the Advisers Act.

[1] See our Hedge Fund and Investment Managers Advisory dated July 27, 1998 for the meaning of “before completion of the transaction.”

[2] Rule 206(3)-2 provides that its existence is not to be construed as relieving an investment adviser of the obligation to act in the best interests of clients, including, for example the duty to obtain best price and execution.  An investment adviser has a fiduciary relationship with its clients that requires fair dealing, in general, and disinterested advice, in particular. 

[3] Section 206 (3) applies not only to investment advisers but also to statutorily defined “affiliates” of an investment adviser if such affiliates act as a principal in a transaction with the adviser’s managed accounts.  See In re Gintel Asset Mgmt. Inc., S.E.C. Release No. 2079 (Nov. 8, 2002).

[4] Supra, note 3.

[5] See, Phillip Goldstein, et al. v. Securities and Exchange Commission, Slip Op. No. 04-1434 (D.C. Cir. June 23, 2006).

For more information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond