Proxy Voting, Principal/Agency Cross Trading, and Form CRS

By September 17, 2019Uncategorized

Over the past month, the SEC has issued guidance on the topics of proxy voting, principal and agency cross trading, and Form CRS. Below we highlight each regulatory update and present an action plan for investment advisers to address the SEC’s guidance.

SEC Releases Guidance to Clarify Investment Advisers’

Proxy Voting Responsibilities

August 2019

Regulatory scrutiny of investment adviser reliance upon proxy advisory firms (“PAFs”) has again become evident with the release of new Commission guidance. This ongoing reliance on PAFs in conjunction with SEC concerns pertaining to adviser adherence to the fiduciary standard of care when voting client proxies underscores the essence of the SEC’s concerns.  At an open meeting held on August 21, 2019, SEC Commissioners issued guidance (hereafter referred to as “Guidance”), by a 3-2 vote, to assist investment advisers when conducting proxy votes on behalf of clients. Indeed, many in the investment adviser industry argue that this guidance is intended to significantly reverse adviser reliance on PAF services.  

Proxy Rule 206(4)-6

In its Guidance, the SEC reiterated advisers’ obligation to fully comply with Investment Advisers Act Rule 206(4)-6 when assuming voting authority on behalf of clients.  The rule and attendant guidance underscore the fiduciary standard relative to the development and execution of investment advice. The regulatory obligations of the adviser will depend upon the scope of voting authority retained by the adviser. To satisfy its fiduciary duty in making any voting determination, the adviser must act in the best interest of the client in accordance with client objectives (the duty of care) and must not place the adviser’s own interests ahead of the interests of the client (the duty of loyalty).

Rule 206(4)-6 requires that advisers exercising voting authority on behalf of clients implement risk-based policies and procedures that are reasonably designed to ensure that the adviser votes in the best interest of its clients and in doing so, fully discloses any attendant conflicts of interest evident in the voting process.  Advisers are not required to accept proxy voting authority, but if they do so, advisers are obligated to affirm with clients the scope of voting arrangements, including clarifying the types of matters to be voted.  Clients may convey voting restrictions on a variety of prospective proxy matters. As with all investment advisory services, the firm’s policies must be adequately disclosed in Form ADV. Furthermore, advisers must keep detailed documentation of each vote tendered by the adviser and must provide this information, along with proxy procedures, to clients upon request.   

The Guidance

In question and answer format, the Guidance addresses the following six topics:

  • Scope of the adviser’s authority and proxy voting responsibilities;
  • Steps to demonstrate that voting decisions are made in a client’s best interest and in accordance with proxy voting policies and procedures;
  • Considerations when retaining a PAF;
  • Steps to respond to potential factual errors, incompleteness, or methodological weaknesses in the PAF’s analysis;
  • Considerations to evaluate a PAF’s material changes in services or operations; and
  • How to determine whether an investment adviser must vote every proxy.

Action Plan

We have chosen not to repeat the questions and answers here – instead, HRL recommends that advisers read the full 26-page Guidance published by the SEC on August 21, 2019. Without question, this Guidance will require advisers to re-evaluate their proxy voting practices, policies, and attendant internal controls especially regarding the utilization of PAF consulting services.  Our recommendations for next steps follow:

Reconsider the scope of proxy voting authority

  1. Should the adviser vote proxies for clients? If yes, the firm must identify the set of clients granting this authority and define the scope of authority retained.  
    1. Example: vote proxies for all clients or only subset(s) of clients.
    1. Example: only vote special meeting votes rather than all votes.
    1. Example: do not vote on matters pertaining to XYZ corporation.
  • Are there general circumstances when votes will be withheld?
    • Example: expense of voting does not justify the benefit, such as when client securities are subject to securities lending arrangements.
    • Example: expense of voting foreign securities may be prohibitive.

Reconsider the voting determination process

  1. Should proxy voting guidelines vary by client/client type?
    1. Example: by client type – should the adviser vote differently for Taft-Hartley clients?
    1. Example: by strategy – should the adviser vote differently for a growth versus income strategy?
  • Document evaluation of issues related to votes.
    • Example: document source information considered for a special vote involving merger or acquisition.
    • Example: document discussion of PAF’s recommendations and how they impact the adviser’s vote.
    • Example: enhance documentation where vote is contested or controversial.
  • Review proxy policy compliance.
    • Example: test to be sure votes are cast in alignment with client-specific requirements and adviser policies.
    • Example: if adviser uses a PAF, test pre-populated votes prior to casting.
    • Example: conduct annual review of voting policies and procedures to ensure they align with client best interests.
  • Elevate proxy voting in the investment process.
    • Example: consider adding each pending proxy votes to investment decision making agendas.
    • Example: retain minutes of proxy voting discussions and determinations.
    • Example: retain evidence that adviser is not merely rubber stamping PAF recommendations by documenting independent thinking and discussion.

Evaluate PAF

  1. Review PAF’s resources, staffing, technology, information sources, and expertise.
  2. Consider PAF’s capabilities to gather and evaluate issuer and client input.
  3. Evaluate PAF’s methodologies in formulating voting recommendations.
  4. Evaluate PAF’s policies and procedures.
  5. Evaluate PAF’s conflict resolution policies and conflict disclosures.

Handling PAF errors, deficiencies, weaknesses

  1. Assess materiality of any PAF errors or deficiencies on actual voting recommendations.
  2. Assess PAF’s controls around data integrity.
  3. Assess PAF’s error correction policies and procedures.
  4. Assess PAF’s transparency in disclosing methodologies and sources of information.
  5. Assess PAF’s due diligence for special votes.
  6. Require PAF to update adviser on changes to its resources, staffing, sources of information, methodologies, etc.

Update adviser policies, procedures, disclosures

  1. Consider more frequent proxy policy and procedure review.
  2. Carefully review proxy procedures and Form ADV disclosures to ensure alignment with actual practices.

For More Information

Follow this link for the SEC’s Proxy Voting Guidance:  Guidance – Proxy Voting Responsibilities of Investment Advisers


SEC Risk Alert: Investment Adviser

Principal and Agency Cross Trading Compliance Issues

September 2019

On September 4, 2019, the SEC issued a Risk Alert to address compliance deficiencies pertaining to principal and agency cross trading practices of investment advisers and attendant compliance with Section 206(3) of the Advisers Act.  These deficiencies were identified by the Commission’s Office of Compliance Inspections and Examinations (“OCIE”) in the course of adviser examinations over a three-year period.  

Rule Summary

Principal trading: Section 206(3) of the Investment Advisers Act makes it unlawful for any investment adviser, directly or indirectly, acting as principal for his own account knowingly to (a) sell any security to a client or (b) purchase any security from a client (“principal trades”), without disclosing to such client in writing before the completion of such transaction the capacity in which the adviser is acting and obtaining the consent of the client to such transaction. Client consent is required at the time of each transaction. Advisers are required to have written risk-based policies and procedures for compliance with all relevant aspects of the Investment Advisers Act. 

Agency Cross trading: Section 206(3) also prohibits an adviser, directly or indirectly, acting as broker for a person other than the advisory client, from knowingly effecting any sale or purchase of any security for the account of that client (“agency cross transactions”), without disclosing to that client in writing before the completion of the sale or purchase the capacity in which the adviser is acting and obtaining the consent of the client to the sale or purchase. However, Rule 206(3)-2 permits certain agency cross transactions without requiring the adviser to provide transaction-by transaction disclosure and consent under certain specified conditions, a detailed in the rule. Advisers are required to have written risk-based policies and procedures for compliance with all relevant aspects of the Investment Advisers Act. 

Common Deficiencies

  • Failure to make proper disclosures and obtain prior client consent for principal transactions.
  • Failure to obtain transaction-by-transaction consents for principal transactions.
  • Failure to fully disclose conflicts and terms of transactions.
  • Seeking client consent after transactions completed.
  • Failure to recognize when the adviser was acting as principal within a private fund.
  • Engaging in agency cross transactions when client disclosures stated that the adviser did not engage in such transactions.
  • Failure to comply with the written consent, confirmation, or disclosure requirements of the rule when engaging in agency cross transactions.
  • Failure to adopt or follow policies and procedures governing principal and agency cross transactions.

Action Plan

If you permit principal or agency cross trading, you are urged to review policies, procedures, and internal controls to ensure that they are in fact compliant with Section 206(3) risk-based regulatory requirements. Upon examination, OCIE will scrutinize all principal and agency cross transactions to determine if the adviser is adhering to the fiduciary standard.  OCIE has determined over the years that principal and agency cross transactions are rife with conflicts of interest which require risk-based internal controls to ensure appropriate disclosure and mitigation.  

Compliance officers should review all principal and agency cross transactions to ensure rule and policy compliance, as well as confirm the ongoing effectiveness of internal controls attendant to these transaction classifications. Below are typical OCIE exam questions related to these transaction types. Compliance officers should mirror these requests when testing internal transactions.

  • List all principal transactions that took place during the Examination Period between current or former clients and/or proprietary or affiliated accounts. Please identify the security, number of shares, price, total dollar value, the client accounts, and the reason for the principal transactions.
  • List all cross transactions that took place during the Examination Period between current or former clients and/or proprietary or affiliated accounts. Please identify the security, number of shares, execution price, pricing sources, total dollar value, the client accounts, and the reason for the crosses.

For More Information

Follow this link to read the Risk Alert: Investment Adviser Principal and Agency Cross Trading Compliance Issues (PDF)


Form CRS Relationship Summary: Amendments to Form ADV

A Small Entity Compliance Guide

September 2019

As we reported in an earlier newsletter, last June the SEC adopted Form CRS with attendant amendments to Form ADV. Form CRS requires registered investment advisers and registered broker-dealers to more fully disclose to retail investors the current and prospective relationship between the firm and client whereby product and service offerings and client access to these products and services are discussed in a question-answer format. Form CRS is designed to assist retail investors with the process of deciding whether to (a) establish an investment advisory or brokerage relationship, (b) engage a particular firm or financial professional, or (c) terminate or modify a relationship or specific service.

On September 9, 2019, the SEC published a new web page designed as “A Small Entity Compliance Guide” relating to Form CRS and Form ADV compliance. The Guide provides a curated set of materials along with a question-answer presentation describing how to comply with the new requirements of Form CRS.

A Small Entity Compliance Guide Highlights

The Guide answers the following questions related to Form CRS:

  • Who must file and deliver a relationship summary?
    • Every investment adviser and broker-dealer firm that offers services to a retail investor.
  • Are the relationship summary requirements in addition to current disclosure and reporting requirements?
    • Yes … Form CRS requirements are in addition to, and not in lieu of, current disclosure and reporting requirements.
  • Can dual registrants or affiliates prepare a single relationship summary rather than a separate relationship summary for each entity?
    • Yes … in fact, the SEC encourages a single summary.
  • What topics do I have to include in my relationship summary?
    • Introduction; Relationships and Services; Fees, Costs, Conflicts, and Standard of Conduct; Disciplinary History; and Additional Information.
  • Do I have to follow certain formatting requirements?
    • Yes … plain English and page limits.
      • Advisers … 2-page limit.
      • Broker-dealer … 2-page limit.
      • Dual registrants … 4-page limit.
  • Do I have to follow any requirements about how I deliver the relationship summary to a retail investor?
    • Yes … electronic delivery must be displayed prominently; paper delivery must display Form CRS as the first document on the pile.
  • When is the first time I have to deliver the relationship summary to a retail investor who is a new or prospective client or customer?
    • Advisers … before or at the time the firm enters into an investment advisory contract with the retail investor.
    • Broker-dealer … before or at the earliest of (a) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (b) placing an order for the retail investor; or (c) the opening of a brokerage account.
    • Dual Registrants … the earlier of the delivery requirements for the investment adviser or broker-dealer.
  • Do I have ongoing delivery obligations?
    • Yes … see Guide for details.
  • Do I have to update my relationship summary?
    • Yes … see Guide for details.
  • Do I have to post the relationship summary on a website?
    • Yes … the current version of Form CRS must be posted prominently on your public website, if you have one.
    • The instructions set forth requirements, including design requirements, for a relationship summary posted on your website.
  • How do I file my relationship summary with the Commission?
    • Advisers … file as Form ADV Part 3 (Form CRS) electronically through the IARD.
    • Broker-dealers … file electronically through Web CRD®.
    • Must be filed using text-searchable format with machine-readable headings to facilitate data aggregation and comparison.
  • Do I have to follow any recordkeeping requirements?
    • Yes … retain copies of Form CRS and dates/recipients in accordance with books and records rule requirements.
  • When do I have to start complying with the new requirements?
    • Advisers … beginning on May 1, 2020 and by no later than June 30, 2020 either as (a) an other-than-annual amendment or (b) part of your initial application or annual updating amendment.
    • Advisers … if you file an application for registration with the Commission as an investment adviser on or after June 30, 2020, Form CRS must be included.
    • Broker-dealers … beginning on May 1, 2020 and by no later than June 30, 2020.

Action Plan

Advisers should develop an action plan to meet Form CRS requirements. Considerations for developing an action plan follow:

  • Convene an in-house Form CRS team to discuss disclosure content. The team should include representatives from investments, compliance, client service, and marketing.
  • Develop a product/service matrix which maps client eligibility to same.
  • Strike a balance between Form CRS information and supporting information links.
  • Determine location for Form CRS posting on the firm’s public website.
  • Look for industry templates to obtain formatting and content ideas. We expect them to come out of the woodwork soon.
  • Develop Form CRS distribution plan, including client messaging.
  • Redline policies and procedures to address new requirements.
  • Train all personnel involved in the Form CRS distribution process.

The Commission’s Division of Investment Management and Division of Trading and Markets offer their assistance to small entities with questions regarding Form CRS and amendments to Form ADV. You may submit a question by email to Alternatively, you may contact the Division of Investment Management’s Office of Chief Counsel at (202) 551-6825 or the Division of Trading and Market’s Office of Chief Counsel at (202) 551-5777.

For More Information

Betsy Rathz

Author Betsy Rathz

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