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News July 31, 2017 Issue

Trade Aggregation and Allocation: Key Practices to Keep Your Advisory Firm Safe

The trading desk is, in many ways, the heart of what your advisory firm does. It’s where client securities are bought and sold, where critical decisions on investments are made – and where missteps can lead not only to bad investment results, but attention from government regulators.

In recent months, the SEC has made a point of showcasing its enforcement campaign against cherry-picking, which occurs when the trading desk allocates trades with favorable results to favored accounts and trades with less favorable results to other clients (ACA Insight, 6/26/17). Beyond that, the agency has clamped down on other practices, such as violations of Rule 105, which prohibits firms from short selling a company’s stock during a restricted period – typically referred to as the five days before a follow-on public offering – and then buying the same security in the offering.

So, with the agency focusing on aggregation and allocation issues, what should a compliance-conscious advisory firm do? Consider the following suggestions:

Best practices

  • Create policies and procedures. "Have as much detail in your policy as possible, setting out how your firm will allocate trades," said Sidley Austin counsel Kara Brown. "The more you can allocate on a pro rata basis (where each client receives the same percentage of trading results), the better, although pro rata does not always work." Bell Nunnally partner Robert Long added that "firms have a fiduciary duty to make sure that trade allocations/aggregations are ‘fair and equitable’ to their clients."
  • Make sure your firm has an allocation methodology. Be prepared with other allocation methods if pro-rata is not applicable. These include "rotation," under which clients rotate through investment opportunities. "As a simplistic example, if you have 10 clients, each one would have the limited investment opportunity presented first to that client once every 10 times a limited opportunity arises," said Mayer Brown partner Stephanie Monaco. "Follow up with your trading desk to make sure the methodology described in your policies and procedures is being followed," said Long.
  • Have a pre-established written allocation for each trade. In other words, said Faegre Baker Daniels partner Jeffrey Blumberg, "If you are buying 10,000 shares of a security for 10 clients, and it was being done on a pro-rata basis, it would state that each client would be allocated 1,000 shares of the order. It prevents the manager or the portfolio manager from being able to take the trade for himself." You should also have a rational basis ready if it turns out that you can’t execute the full trade, say if only 9,000 of the above-referenced 10,000 shares were available. How would the shares be allocated among the 10 clients? The firm should have written policies and procedures that establish how partial fills are handled – commonly on a pro rata basis, but that is not mandatory if there are other concerns that are material, he said.
  • Be consistent. Don’t switch from one allocation methodology to another frequently; document your allocations appropriately to allow for testing, said Brown. "Properly disclosed policies are important with respect to this issue."
  • Disclose. Your aggregation and allocation methodology should follow what is in your firm’s policies and procedures. If your firm needs to change that methodology, such as, for instance, switching from pro-rata to rotation, clients must be informed, said Monaco. A number of the SEC enforcement actions, particularly those involving tradeaways, charge the adviser with not disclosing the activity to clients.
  • Document. "It’s very important that you document how trades are allocated, by whichever allocation methodology is used," said Brown. "If you are making ostensibly ad hoc decisions, you need to be able to support those decisions, especially if a number of years pass between when you made them and when the agency may ask about them."
  • Avoid favorites. This is where cherry-picking comes in, when a trading desk allocates the best trade results to a proprietary account or certain favored accounts. "Don’t favor certain clients in a limited investment opportunity," said Monaco. "For instance, an adviser might fail to recognize certain proprietary accounts owned by the adviser, and therefore might steer profitable trades toward them."

The SMC no-action letter

One of the guideposts for an advisory firm when performing aggregation and allocation is a September 1995 SEC Division of Investment Management no-action letter, known as the "SMC Capital letter." In it, the Division staff tells the adviser, SMC Capital, that it would not recommend enforcement action for its aggregations plan if the adviser follows through on representations made in the letter.

The staff, in the letter, lists 10 of the adviser’s representations, which advisers today should consider best practices for their own aggregation arrangements, Monaco said. The particulars for advisers today involved in individual arrangements may differ in some respects (such as in the method of allocation, i.e., pro rata or something else) from the below, which focused solely on the SMC Capital proposed arrangement. With that in mind, it would be wise for advisers to seek out legal or consultant advice before proceeding.

The representations in the SMC Capital no-action letter include:

  • Policies for the aggregation of transactions will be fully disclosed in the adviser’s Form ADV and separately to the adviser’s existing clients and the broker-dealers through which the orders will be placed;
  • The adviser will not aggregate transactions unless it believes that aggregation is consistent with its duty to seek best execution for its clients and consistent with the terms of the adviser’s investment advisory agreement with each client involved;
  • No advisory clients will be favored over any other client, and each client that participates in an aggregated order will participate at the average share price for all the adviser’s transactions in that security on a given business day, with transaction costs shared pro rata based on each client’s participation in the transaction;
  • The adviser will prepare, before entering an aggregated order, a written statement specifying the participating client accounts and how it intends to allocate the order among those accounts;
  • If the allocation order is filled in its entirety, it will be allocated among clients in accordance with the allocation statement, and if it is only partially filled, it will be allocated pro rata based on the allocation statement;
  • Notwithstanding the foregoing, the order may be allocated on a basis different from that specified in the allocation statement if all client accounts receive fair and equitable treatment and the reason for the different allocation is explained in writing and is approved in writing by the adviser’s compliance officer no later than one hour after the opening of the markets on the trading day following the day the order was executed;
  • The adviser’s books and records will separately reflect, for each client account with orders that are aggregated, the securities held by and bought and sold for that account;
  • Funds and securities of clients whose orders are aggregated will be deposited with one or more banks or broker-dealers, and neither the clients’ cash nor their securities will be held collectively any longer than necessary to settle the purchase or sale in question on a delivery versus payment basis;
  • The adviser will receive no additional compensation or remuneration of any kind as a result of the proposed aggregation; and
  • Individual investment advice and treatment will be accorded to each advisory client.