SEC warns advisers to get client consent before trading from own accounts

Compliance experts say violators may not realize they're out of bounds

Sep 5, 2019 @ 1:55 pm

By Mark Schoeff Jr.

Investment advisers are falling short of regulatory requirements regarding the sale of investments to clients out of the advisers' own accounts, the Securities and Exchange Commission warned this week.

In a Wednesday risk alert from the Office of Compliance Inspections and Examinations, the agency said it has noticed advisers engaging in principal trading without following the strict rules governing such transactions. Problems also have cropped up when advisers arrange trades between clients and affiliated brokers, which is known as agency cross-selling.

"Advisers did not make the required written disclosures to the clients or obtain the required client consent," the risk alert states.

Clients potentially can be harmed in principal trading because advisers have an incentive to make money for their own accounts that could reduce the return for their clients.

This situation can occur when an adviser dips into her own inventory of fixed-income products or illiquid securities or when she sells investments in a private fund in which she has at least 25% control.

The SEC doesn't prohibit principal trading but it does require advisers to disclose conflicts of interest and get client approval in writing on a transaction-by-transaction basis.

"It's a heavy lift," said Gail Bernstein, general counsel at the Investment Adviser Association. "The SEC wants to make sure it puts protections around that conflict."

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Principal trading is mostly associated with broker-dealers, who sometimes keep their own inventory of investment products and sell them to customers. But the SEC alert indicates that investment advisers also are engaging in the practice.

Adviser disclosure forms filed in April show that 1,032 advisers conducted principal transactions this year, according to statistics compiled by the IAA.

The IAA analysis also shows that 399 advisers conducted agency cross transactions with affiliated brokers. There were 12,993 investment advisers registered with the SEC as of April.

"Clearly this is happening and [advisory] firms aren't recognizing it," said G.J. King, president of RIA in a Box, a compliance consulting firm. "Systems and controls need to be in place to ensure personal accounts for advisers are closely monitored and reviewed to identify potential principal trading issues."

Advisers need to understand the intricacies surrounding principal trading, said Todd Cipperman, principal at Cipperman Compliance Services.

"Assuming you're doing the right thing and assuming you're a good person doesn't mean you're complying with the rules," Mr. Cipperman said. "It's not intuitive to know that principal transactions require disclosure and consent."

In fact, it goes beyond that, according to the SEC's alert. A footnote states that under the agency's recent interpretation of the standard of conduct for investment advisers, an investment adviser has the responsibility to select a broker-dealer who will provide best execution of client trades.

"Just because you've checked the box on each of the specific requirements [for principal trading], that's not the end of your review of the transaction," Ms. Bernstein said.

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