From the November 2007 issue of Boomer Market Advisor • Subscribe!

Don't cross the line when executing trades

When investment advisors engage in cross-trading, they need to avoid crossing over into forbidden regulatory territory. Certain types of cross-trades require full compliance with Rule 206(3)-2 under the Investment Advisers Act of 1940.

The SEC has defined a cross-trade as a transaction between two accounts managed by the same advisor. An advisor can execute a cross-trade on an agency or principal basis.

With an agency transaction, an advisor arranges a trade between different advisory clients. In other types of agency transactions, an advisor arranges a trade between a brokerage customer and an advisory client. With principal transactions, an advisor, acting for its own account, buys a security from, or sells a security to the account of a client.

Compliance with Rule 206(3)-2 is required in any transaction where an investment advisor, or any person controlling, controlled by, or under common control with this investment advisor acts as broker for both the advisory client and for another person on the other side of the transaction.

Regulators are deeply concerned by principal and agency transactions, because they create the potential for advisors to engage in self-dealing. Principal transactions may lead to price manipulation or the placement of unwanted securities in a client's account. The primary concern with agency transactions is that the adviser might use them to earn additional compensation.

Compliance with Rule 206(3)-2

The SEC has taken the position that Rule 206(3)-2 applies to both agency cross trades and principal transactions. Compliance with Rule 206(3)-2 requires all of the following:

  • The advisory client must execute a written consent in advance of the trade that authorizes agency cross-transactions. This written consent must come after full written disclosure that the investment advisor, or some other person, will act as a broker for, receive commissions from, and have a potentially conflicting division of loyalties and responsibilities to both parties to the transaction.

  • The advisor must send each client a written confirmation at or before the completion of each transaction that includes (1) a statement of the nature of this transaction, (2) the date this transaction took place, (3) an offer to furnish upon request the time when this transaction took place and (4) the source and amount of any other remuneration received or to be received by the investment advisor.

  • The advisor must send each client an annual statement identifying the total number of these transactions since the last summary, and the total amount of all remuneration received or to be received by the investment advisor. Each written statement must conspicuously disclose that consent may be revoked.

The prior disclosure and consent requirements for principal transactions are slightly different than for agency cross transactions. The disclosure and consent requirements must be met prior to completion of each and every principal transaction. It is not enough to have a blanket written consent that is given in advance by the client at the beginning of the advisory relationship. Furthermore, disclosure in the advisor's Form ADV is not sufficient.

Even if the advisor fully complies with Rule 206(3)-2, it is not relieved from acting in the best interests of the advisory client. The advisor's fiduciary duty includes its obligations with respect to best price and execution for the particular transaction. The advisor must also comply with its disclosure obligation under subparagraphs (1) or (2) of section 206 of the Investment Advisers Act and other applicable provisions of the federal securities laws.

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