A recent Securities and Exchange Commission (SEC) risk alert on cross trades and lead trades included advice and warnings based on over 20 reviews of investment advisers who have engaged in cross trades or trades principal involving fixed income instruments. While not specifically named by the SEC, Akin Gump’s attorneys, in a recent article, explained how this would apply to CLO managers.
Cross trades, says J. Stephen King, partner at Practus, LLP, are particularly beneficial to an advisor’s client when the bid-ask spread is wide. The cross-trade price for each client is in the middle of the bid-ask spread, so each client receives a better price than they might get if each client trades in the marketplace. Cross trades are probably more beneficial for fixed income instruments or similar instruments that are less liquid and have a wider bid-ask spread.
Over the past few years, King said, the SEC has initiated a number of enforcement actions relating to advisers’ cross-trading practices, particularly involving moves that the trader may not have considered to be transactions. crossed. For example, the trader may have sold a security for one account and later repurchased the same security for another account with the same broker. The trader may have believed that these two trades did not constitute a “cross trade” since the security was sold to the broker and later redeemed. However, if the sale and redemption were arranged in advance, or the sale and redemption was effected shortly thereafter, and the broker essentially took no market risk when he bought the title. King notes that the SEC has made it clear that it considers the two transactions to constitute a cross transaction. SEC staff have long requested information on cross-trading practices, but the practice has become more urgent recently, and staff observations have prompted them to issue two risk alerts on the practice, King says.
The concerns of SEC staff center on the conflicts of interest involved in cross-transactions. The advisor is the trustee of each account and is required to act in the best interests of each account.
There are really two main concerns from an SEC perspective, one is that a security transferred from one account to another in a cross trade is not suitable for every account. The other is that the cross trade price is not “best execution” for both clients, and one or both clients would have done better to trade in the open market. Of particular concern are the cross trades interposed by the broker as the trader probably did not go through the normal process of a cross trade.
“The advisor should train their traders to know that just because a dealer is involved in a trade does not mean that a pair of trades would not be considered a cross trade,” King said.
How it applies to CLOs
Deborah Festa, Akin Gump partner, spoke about the importance of the SEC whistleblowing for registered CLO managers, other participants and lawyers. The practices mentioned in the SEC alert of July 21 apply to CLO managers in the same way as those who manage hedge funds.
“Our recent article on the SEC Alert of July 21 is more of a reminder as there was nothing specifically new about what the SEC said regarding the rules on cross trades and master trades,” he said. declared Festa. The document, Festa added, is an important reminder of how the rules and guidelines apply not only to hedge fund managers, but also to CLO managers,
Festa added that the rules extend to filing ADV forms as well as implementing compliance programs. “The SEC occasionally does sweeps of CLO managers. For some managers, previous scans on this same issue have come about unexpectedly, and managers need to be prepared with their disclosure documents, policies and procedures. “
She added that CLO managers should check annually whether corrective or other action is needed.
In its alert, the SEC spoke about advisers who obtain the appropriate consent from affected clients and provide them with the appropriate disclosure before they complete trades or trades. The agency also spoke about the importance of avoiding conflicts of interest in the exercise of these trades. Buyers and sellers should ideally act independently of each other without influencing each other or, in other words, be “at arm’s length”. In addition to suffering from SEC enforcement, failure to comply with these conditions may result in legal action from the holders of the notes purchased or sold whose interests were compromised when the advisers effected these transactions.
Industry response to the rules
The CLO industry takes a variety of approaches to meet its unique compliance needs.
“Managers are generally well aware of their obligations, although it helps to have a strong legal and compliance function fully engaged so that there is more scrutiny on this aspect of the business,” Festa said. .
SEC staff members also observed in the July 21 Risk Alert that advisor compliance policies, procedures and client disclosures were inadequate. Staff emphasized the importance of defining the types of activities that are considered cross-trades. If dealer enforced cross trades are not clearly defined as cross trades, traders may not follow the cross trade policies and procedures for these trades. Compliance teams, in turn, may not be aware of this. Therefore, cross trades may be performed in a manner inconsistent with what is disclosed to clients.
Industry experts recognize that it can be difficult to define when sell / buy back transactions would be considered cross trades. “If the sell and buy back are spaced a month apart, the two trades probably wouldn’t be considered cross trades. However, if the period is shorter, on the same day or in a few days, the two trades are more likely to be considered cross trades, ”says King.
“Some of the more conservative companies in the industry prohibit traders from repurchasing a security from the same broker for another account in a few days, while others would have a longer or shorter period than that. But, when you sell a security to a broker, it doesn’t mean that you can never buy that security for another account, it’s just a matter of whether enough time has passed between trades for the pair to of transactions is not considered a cross. Trade.
“The advisor 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 said.
He added that the compliance department should also be aware of these types of transactions and monitor trading activity to identify them. More than half of the deficiencies observed by SEC staff related to issues with advisor compliance policies and procedures. Compliance departments should develop reasonable policies and procedures and monitor trading activities to ensure that policies and procedures are followed.
The recent risk alert also highlights the importance of solid information about cross-trading practices. The disclosure should not only describe the advisor’s cross-trading practices, but also the nature and extent of the conflict of interest involved in these types of transactions. Advisors should review their disclosures and modify them if necessary.
In general, what is essential is to be aware of the regulatory environment surrounding these professions and to build a global culture of compliance in companies.
“It is important that legal advisers and compliance officers of asset managers keep an eye on the guidelines that SEC staff issue from time to time, even though managers at CLO may not be mentioned as a specific advisor class. Overall, in the context of SEC reviews, the critical keys for managers are evidence of strong policies and procedures, regular back-testing and demonstration of an overall culture of compliance, ”said Festa.