Riskless principal

There are four ways an investment advisor might purchase securities for a client.

• A “riskless principal transaction” arises where an adviser (acting through an affiliated broker-dealer) purchases or sells a security for an advisory client. In executing the transaction, the adviser simultaneously buys or sells the security for the client through an offsetting transaction in the account of an affiliated broker-dealer. In this way, the security notionally, passes through the account of the affiliate broker-dealer who charges a small markup or markdown rather than a commission. Although resembling agency transactions, the SEC treats riskless principal transactions as principal transactions fully subject to Section 206(3) of the 40 Act. The SEC has brought a number of enforcement actions involving riskless principal transactions under Section 206(3).
• A “cross transaction” is a transaction in which an adviser causes the purchase and sale of a security between two advisory client accounts without charging a fee for effecting the transaction. Where the client accounts are not owned by the adviser, a cross transaction is not a principal transaction subject to Section 206(3) because the adviser would not be “acting as broker” (assuming that neither no fee is charged for effecting the trade. If the adviser charges a fee the transaction would be deemed an “agency cross transaction” as discussed below). The SEC has cautioned that cross transactions are nevertheless subject to Sections 206(1) and (2) of the Advisers Act and that an adviser may need to disclose information about cross transactions.
• An “agency cross transaction” is where an investment adviser acts in relation to a transaction in which an affiliated broker-dealer acts as broker for both an advisory client and another person on the other side of the transaction and the affiliated broker-dealer charges a transaction fee for effecting the trade. Section 206(3) applies to agency cross transactions, even though neither the adviser nor the affiliated broker-dealer acts as principal with respect to the trade because the affiliate is “acting as broker for a person other than such client”.

However, Rule 206(3)-2, permits an investment adviser to effect agency cross transactions based on prospective, blanket consent from an advisory client. The rule contains a number of conditions, including certain disclosure and reporting obligations and is not available where (a) the adviser or its affiliated broker-dealer recommend the transaction to both sides of the trade or (b) when a security trades on a principal basis (which would typically result in a riskless principal transaction, as discussed above).

• “Agency Transactions” are where an adviser executes a securities transaction through a broker-dealer who acts as agent on behalf of the adviser’s client. The broker-dealer charges a commission for representing the adviser’s client in effecting the trade. Section 206(3) does not apply to agency transactions, even if the broker-dealer is an affiliate of the adviser (and assuming that the affiliate broker-dealer does not also represent the person on the other side of the transaction). However, in these circumstances, an adviser has a general obligation to disclose that it may use an affiliated broker-dealer and that the adviser will indirectly benefit from any commissions paid to the affiliated broker-dealer.