A recent Securities and Exchange Commission (SEC) Risk Alert on cross trades and principal transactions included guidance and warnings based on over 20 examinations of investment advisers that engaged in cross trades or principal transactions involving fixed-income instruments. Although not specifically singled out by the SEC, Akin Gump attorneys, in a recent write-up, discussed how this would apply to CLO managers.
Cross trades, explains J. Stephen King, a partner at Practus, LLP, are particularly beneficial to an adviser’s client when the bid-ask spread is wide. The cross trade price for each client is at the midpoint of the bid-ask spread, which results in each client receiving a better price than they might have if each client carried out transactions in the market. Cross trades are likely more advantageous for fixed-income instruments or similar instruments that are less liquid and have a wider bid-ask spread.
In recent years, King said, the SEC has brought a number of enforcement actions relating to advisers’ cross trading practices, particularly involving moves that the trader may not have considered to be cross trades. For example, the trader might have sold a security for one account and later repurchased the same security for another account from the same dealer. The trader may have believed that these two trades did not constitute a “cross trade” since the security was sold to the dealer and repurchased later. However, if the sale and repurchase were prearranged, or if the sale and repurchase were conducted close in time, and the dealer essentially did not take any market risk when it purchased the security. King notes that the SEC has made it clear that it regards the two trades as constituting a cross trade. SEC staff has requested information about cross trading practices for a long time, but the practice has taken on more urgency recently, and the staff’s observations have led it to publish two Risk Alerts on the practice, King explains.
The SEC staff’s concerns center on the conflict of interest involved in cross trading. The adviser is a fiduciary to each account and is obligated to act in each account’s best interest.
There are really two main concerns from the SEC perspective, one is that a security that is transferred from one account to another in a cross trade is not suitable for each account. The other is that the cross trade price does not constitute “best execution” for both clients, and that one or both clients would have been better off transacting in the open market. Dealer-interposed cross trades are of particular concern because the trader likely did not go through the normal process for a cross trade.
“The adviser has to train its traders to be aware that just because a dealer is involved in a trade, doesn’t mean that a pair of trades wouldn’t be considered a cross trade,” King says.
How it applies to CLOs
Akin Gump Partner Deborah Festa talked about the importance of the SEC's alert to registered CLO managers, other participants and lawyers. The practices mentioned in the July 21 SEC alert apply to CLO managers in the same way as those that manage hedge funds.
"Our recent write-up on the SEC July 21 alert is more of a reminder since there was nothing specifically new in what the SEC said when it comes to the rules on cross trades and principal transactions,” Festa said. The document, Festa added, is an important reminder of how the rules and guidance apply not just to hedge fund managers, but to CLO managers as well,
Festa added that the rules extend to filing ADV forms as well as implementing compliance programs. "The SEC occasionally performs sweeps of CLO managers. For some managers, the prior sweeps on this very issue have come unexpectedly, and managers should be prepared with their disclosure documents, policies and procedures.”
She added that CLO managers should be back-testing on an annual basis whether remediation or other measures are needed.
In it’s alert the SEC talked about advisers obtaining the appropriate consent from, and provide the proper disclosure to, the clients involved before completing the transactions or the trades. The agency also talked about the importance of avoiding conflicts of interest in doing these trades. Buyers and sellers should ideally act independently of one another without influencing the other or, in other words, be at “arm’s length.” Aside from suffering from SEC enforcement, non-compliance with these terms can result in lawsuits from those holding the notes that were being bought or sold and whose interests were compromised when advisers performed these trades.
Industry response to rules
The CLO industry takes various approaches to addressing its particular compliance needs.
“Managers are usually well aware of their obligations, although it helps to have a robust legal and compliance function fully engaged so there are more eyes on this aspect of the business," Festa said.
SEC staff members also observed in the July 21 Risk Alert that advisers’ compliance policies, procedures and disclosures to clients were inadequate. The staff noted the importance of defining the types of activities that are considered cross trades. If dealer-imposed cross trades are not clearly defined as cross trades, then traders might not follow the cross trade policies and procedures for these trades. Compliance teams, in turn, might not be aware of them. As a result, cross trades may be conducted in a manner that is inconsistent with what is disclosed to clients.
Industry experts acknowledge that defining when sale/repurchase trades would be considered cross trades can be difficult. “If the sale and repurchase are a month apart, the two trades likely would not be considered a cross trade. However, if the time period is shorter, same day or within a few days, the two trades are more likely to be considered a cross trade,” King explains.
“Some of the industry’s more conservative firms prohibit traders from repurchasing a security from the same dealer for another account within a few days, while others would have a longer or shorter period than that. But, when you sell a security to a dealer, it does not mean you can never buy that security for another account, it is just a matter of whether sufficient time has passed between trades so that the pair of trades would not be considered a cross trade.
“The adviser needs to educate traders and come up with policies that clearly define when a pair of trades would be considered dealer-imposed cross trades,” King says.
He added that the compliance department must also be aware of these types of trades and monitor trading activity to identify them. Over half of the deficiencies observed by the SEC staff related to issues with the advisers’ compliance policies and procedures. Compliance departments need to develop reasonable policies and procedures and monitor trading activity to ensure that the policies and procedures are being followed.
The recent Risk Alert also emphasizes the importance of robust disclosures regarding cross-trading practices. The disclosure should not only describe the adviser’s cross-trading practices, but also the nature and significance of the conflict of interest involved in these types of trades. Advisers should review their disclosures and amend them as appropriate.
Generally, what is key is to be aware of the regulatory environment surrounding these trades and to build an overall culture of compliance in firms.
"It is important for the general counsels and chief compliance officers of asset managers to keep an eye on guidance that the SEC staff releases from time to time, even though CLO managers might not be mentioned as a specific advisor class. Overall, in the context of SEC exams, critical keys for managers are evidence of robust policies and procedures, regular back-testing and demonstrating an overall culture of compliance," Festa said.
