SEC Continues Scrutiny of Private Fund Cross Trades

The SEC continues to scrutinize principal and cross-trade transactions in the private fund world. Are such trades illegal? No. In fact, with sufficient disclosures (and supervisory controls, of course), a private fund adviser can conduct principal and cross trades, which can offer certain benefits to the funds under management. For example, cross trades can be utilized to rebalance funds and save on transaction costs.

So, why is the SEC concerned with cross trade transactions? Cross trading raises various compliance risks, including those associated with disclosure, best execution, and conflicts of interest.

For example, in short, the SEC will scrutinize cross trades as the practice gives rise to the opportunity to favor one fund over another by, for example, moving a position, perhaps a losing position, to another fund to improve the return of the original fund. This creates a conflict, since the transaction benefits the investors of one fund at the expense of investors in the other fund. Best execution is always a concern also, as the pricing for any cross trades must be competitive with a view to the market for the security traded.

Illustrative of the SEC’s focus on this topic, is a recent SEC enforcement action, dated February 24, 2020, In the Matter of Lone Star Value Management LLC and Jeffrey Eberwein, where the SEC cited 19 instances of principal cross trades between two funds managed by Lone Star and two transactions between a Lone Star fund and a separately managed account. The SEC Order pointed out that “These 21 trades were made on a principal basis because Eberwein’s ownership stake in the Lone Star fund involved in each of these trades was more than 35% during the relevant time period. Lone Star failed to disclose in writing that it engaged in these principal transactions and did not obtain client consent before the completion of each of the transactions as required under Section 206(3) of the Advisers Act.”

The SEC Order continued by outlining disclosure requirements for such transactions:

“Section 206(3) of the Advisers Act prohibits an investment adviser from engaging in or effecting a transaction on behalf of a client while acting either as a principal for its own account, or as broker for a person other than the client, without disclosing in writing to the client, before the completion of the transaction, the adviser’s role in the transaction, and obtaining the client’s consent.”

As is often the case in enforcement actions, the SEC went on to cite concerns with the firm’s written policies and procedures, specifically Lonestar’s failure to implement written policies and procedures “reasonably designed to prevent violations of the Advisers Act and the rules thereunder, a violation of Section 206(4) of the Advisers Act and Rule 206(4)-7” (the compliance program rule). Clearly, just having the right policies and procedures in place isn’t enough; a firm must also enforce them.

Action items:

  1. First, if your firm engages or may engage in principal or cross trades, ensure that you have drafted written policies and procedures to address oversight, including the disclosure requirements relating to cross and principal trades, pursuant to Section 206(3) of the Advisors Act. In the private fund world, get approval from your limited partner advisory committee involved prior to effecting principal transactions, agency cross trades (or other affiliate transactions that give rise to conflicts of interest) to make timely disclosure and consent quicker and more practical.  And don’t overlook documentation (perhaps, in an investment memorandum) of such transaction decisions.
  2. Next, to monitor for cross and principal trades, establish a surveillance system that tests for cross-trading activity by conducting a review of transactions in the same security over a period of time, looking both at the buy and sell prices and the amount of any commission or markup.
  3. Incorporate this issue into your ongoing training program; discuss an SEC case (including disciplinary measures) to highlight regulatory concerns on this topic and you will most certainly garner staff attention during the training presentation.
  4. Finally, best practice is to further review this topic as part of your firm’s annual review.

If your firm needs assistance in understanding these transactions and your obligations for such, contact us.


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