Staff Statement on Investment Company Cross Trading
Division of Investment Management Staff
March 11, 2021
This Staff Statement is presented by the Staff of the Division of Investment Management (the “Staff”). In this statement, the Staff addresses certain aspects of investment company cross trading. The Staff is interested in feedback on ways to enhance the regulatory regime governing investment company cross trading.
This Staff Statement is not a rule, regulation, or statement of the Securities and Exchange Commission (the “Commission”). Furthermore, the Commission has neither approved nor disapproved its contents. This Staff Statement has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.
Today, under rule 17a-7 under the Investment Company Act of 1940 (the “Act”), securities transactions may be effected between a fund and certain affiliates (referred to as “cross trades”), provided the transactions meet certain protective conditions.[i] For example, transactions between a fund and another fund managed by the same adviser must meet the conditions of this rule, unless the Commission provides a separate exemption. Among the protective conditions, Rule 17a-7 generally requires that cross trades: (a) involve a security for which market quotations are readily available; and (b) be effected at the independent current market price of the security. Rule 17a-7 contains a number of other requirements for cross trades, including that the transaction be consistent with the policy of each fund; that no commission, fee or other remuneration be paid in connection with the transaction; that the board (including a majority of independent directors) take certain actions; and that the fund maintain certain records.[ii]
In December 2020, the Commission adopted a new rule under the Act that addresses valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company (the “Valuation Rule”).[iii] The Valuation Rule includes a definition of the term “readily available market quotations” that may affect current investment company cross-trading practices under rule 17a-7.[iv] The Commission has long stated that the phrase “for which market quotations are readily available” has the same meaning under rule 17a-7 and under the valuation provisions of the Act and rules thereunder.[v] When the Commission proposed the Valuation Rule, it asked whether the proposed definition of when market quotations are readily available under the Act was appropriate and whether it would cause any compliance issues with any other provision of the federal securities laws.[vi]
In response, a number of commenters stated that funds and their affiliates regularly engage in cross trades of certain fixed-income securities that they believed would not qualify as having readily available market quotations under the definition of that term in the Valuation Rule.[vii] In adopting the Valuation Rule, the Commission recognized that, whenever it defines a term, to the extent market participants currently engage in practices that are not consistent with that definition, they will need to conform their practices.[viii] As a result, certain securities that some may have previously viewed as having readily available market quotations and being available to cross trade under rule 17a-7 may not meet the definition in the Valuation Rule and thus would not be available for such trades after September 8, 2022, the compliance date of the Valuation Rule. The Commission also noted that it understood many cross trades were done taking into consideration certain letters issued by the Staff that address, among other things, the application of the term readily available market quotations in the context of certain transactions under rule 17a-7.[ix] These letters are being reviewed to determine whether they, or certain portions of these letters, should be withdrawn. In addition, as the Commission stated in adopting the Valuation Rule, consideration of potential amendments to rule 17a-7 is on the rulemaking agenda.[x]
The Commission initially adopted rule 17a-7 in 1966.[xi] Although the Commission has amended the rule a few times since 1966, as discussed in the release adopting the Valuation Rule, funds now invest in a greater variety of securities and other instruments, some of which did not exist decades ago. As such, this may present different or more significant valuation challenges and may present other considerations relevant to the conflicts of interest that cross trades present.[xii] For example, funds that invest primarily in fixed income instruments have expanded from around $800 billion in assets to over $4.5 trillion in just the last 20 years.[xiii] The Staff also has gained considerable experience with the operation of the rule in the decades since its adoption, including through a number of enforcement actions that the Commission has brought under this rule. We believe that funds’ cross trading practices have evolved over the last several decades and, accordingly, we believe it is once again appropriate to assess what, if any, changes to rule 17a-7 may be warranted.[xiv]
As the Staff evaluates these matters, feedback would be helpful in evaluating what, if any, recommendations the Staff might make to the Commission in this area. Identified below are areas where feedback would be particularly helpful.
Appendix A outlines additional general topics that the Staff expects to consider in connection with formulating any recommendations to the Commission. The Staff welcomes engagement on these topics.
- Current cross trading practices. Under what circumstances do funds currently engage in cross trading? To what extent do funds’ current cross trades not have readily available market quotations as defined in the Valuation Rule? What amount of cross trading occurs between two registered investment companies as compared to cross trading between a registered investment company and another type of affiliate? What types of securities do funds currently cross trade? What types of securities do advisers believe they could cross trade under current rule 17a-7, but choose not to rely on the rule and instead to trade in the market? What types of securities would advisers like to cross trade but believe they cannot do so under the current rule 17a-7?
- Securities Eligible to Cross Trade: Pricing and liquidity. What are the advantages and disadvantages of the threshold requirement in rule 17a-7 that a security have a “readily available market quotation”? What sources of independent current market prices are used to cross trade securities under rule 17a-7? What are the liquidity characteristics of securities that funds currently cross trade? Are cross traded securities valued in the same manner under rule 17a-7 as they are under section 2(a)(41) of the Act? What other criteria for the transactions would protect against conflicts of interest or other risks of cross trades?
- Controls. What kinds of controls do advisers have in place to govern cross trading? What controls do advisers have in place to assess whether a cross trade is consistent with the adviser’s fiduciary obligation to its clients and is in the best interest of both the buying and selling fund? What controls do funds have in place to assess whether a cross trade is consistent with the investment policy of both the buying fund and the selling fund?
- Market transparency. How does cross trading affect market transparency? How might transparency be enhanced for all market participants? To what extent might cross-trades affect market efficiency because they are not publicly reported?
If you would like to let the staff know your views regarding these issues, we are providing an email box as a convenient method for you to communicate with us: we recommend that you send an email to “IM-Rules@sec.gov” and insert “Cross Trading” in the subject line. Feedback would be most helpful if provided within 30 days after publication of this statement on the Commission’s website.
The Staff anticipates making submissions public.
Additional Topics of Interest
- Cross trading practices
- Purposes for cross trading different types of securities
- Purposes for cross trading by investment strategy of fund, or by type of affiliated entity
- Connections between the ability of a fund to cross trade a security and a determination to execute a trade in that security
- Market conditions that make cross trading more or less beneficial to funds or their investors
- Prevalence of cross trading among fund complexes of different sizes
- Competitive advantages that cross trading may provide to certain types of funds or fund complexes
- Pricing and liquidity
- Protective characteristics of pricing requirements under section 2(a)(41) and rule 17a-7
- Relationship between the value of securities as determined under section 2(a)(41) and under rule 17a-7
- Potential sources of observable pricing information that could inform the price of a security to be cross traded
- Potential valuation frameworks that could be used for cross trades, such as FASB Accounting Standard Codification Topic 820: “Fair Value Measurement”
- Role of independent pricing services or other independent pricing sources
- Cross trading systems
- Potential role of trading venues or platforms in enhancing price discovery and liquidity
- Treatment of custodial fees or transaction fees for the funds participating in a cross trade on a venue or platform
- Existing controls that funds and advisers have in place to ensure that a cross trade is consistent with the investment strategy and targeted risk profile of each fund or affiliate
- Documentation and recordkeeping requirements to facilitate oversight by fund compliance, boards, and advisers
- Extent to which concerns about effects of cross trades on funds and their investors may vary according to the type of instrument to be cross traded or the source of pricing information
- Reporting of cross trades to the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (“TRACE”), or the Municipal Security Rulemaking Board’s Real-Time Transaction Reporting System, as applicable, or other similar system that provides market transparency
- Transaction-specific information about cross trades, in addition to transaction size and price, that would be beneficial for market transparency
- Potential costs and benefits
- Circumstances when a cross trade benefits both funds and their investors and the extent and nature of those benefits
- Circumstances when a cross trade could benefit one fund and its investors but harm the affiliate and its investors
- Differences in potential harms from cross trading depending on the type of instrument that is cross traded or the types of funds or affiliates involved in the trade
[i] Section 17(a) of the Act prohibits, among other transactions, any affiliated person of a registered fund, or any affiliated person of such a person, from selling a security or other property to, or purchasing a security or other property from, the fund.
[ii] See also Independent Directors Council, SEC Staff No-Action Letter (Oct. 12, 2018) (responding to a request describing an approach to affiliated transaction reviews that fully utilizes the chief compliance officer and the compliance rule structure, and stating that the staff would not recommend enforcement action if a fund follows that approach).
[iii] See Good Faith Determinations of Fair Value, Investment Company Act Release No. 34128 (Dec. 3, 2020) [86 FR 748 (Jan. 6, 2021)], available at https://www.govinfo.gov/content/pkg/FR-2021-01-06/pdf/2020-26971.pdf (“Valuation Rule Adopting Release”).
[iv] “[A] market quotation is readily available only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable.” Rule 2a-5(c).
[v] See Exemption of Certain Purchase or Sale Transactions Between a Registered Investment Company and Certain Affiliated Persons Thereof, Investment Company Act Release No. 11676 (Mar. 10, 1981) [46 FR 17011 (Mar. 17, 1981)], at n.16.
[vi] Good Faith Determinations of Fair Value, Investment Company Act Release No. 33845 (Apr. 21, 2020) [85 FR 28734 (May 13, 2020)] at 28749, available at https://www.govinfo.gov/content/pkg/FR-2020-05-13/pdf/2020-08854.pdf. During 2020, but unrelated to the adoption of the Valuation Rule, the Fixed Income Market Structure Advisory Committee issued recommendations related to investment company cross-trading. See “FIMSAC Recommendation Regarding Modernizing Rule 17a-7 under the 1940 Act” (June 1, 2020), available at https://www.sec.gov/spotlight/fixed-income-advisory-committee/fimsac-recommendation-internal-fund-cross.pdf.
[vii] See, e.g., Comment Letter of the Investment Company Institute (Jul. 16, 2020), available at https://www.sec.gov/comments/s7-07-20/s70720-7433367-220249.pdf; Comment Letter of Capital Research and Management Company (Jul. 21, 2020), available at https://www.sec.gov/comments/s7-07-20/s70720-7464404-221164.pdf.
[viii] Valuation Rule Adopting Release, 86 FR at 773.
[ix] See, e.g., United Municipal Bond Fund, SEC Staff No-Action Letter (Jan. 27, 1995) and Federated Municipal Funds, SEC Staff No-Action Letter (Nov. 20, 2006).
[x] Valuation Rule Adopting Release, 86 FR at 773.
[xi] In 1966, the Commission adopted the original rule 17a-7, which provided an exemption only for purchase or sale transactions involving securities traded on a national securities exchange. See Investment Company Act Release Nos. 4697 and 4604 (Sep. 8, 1966 and May 20, 1966) [31 FR 12092 and 31 FR 7913 (Sep. 16, 1966 and Jun. 3, 1966)]. In 1974, rule 17a-7 was amended to apply also to purchases or sales of certain securities traded over-the-counter. See Investment Company Act Release Nos. 8494 and 8199 (Sep. 13, 1974 and Jan. 28, 1974) [39 FR 36002 and 39 FR 5506 (Oct. 7, 1974 and Feb. 13,1974)]. The Commission replaced and modernized rule 17a-7 with its existing framework in 1981. Investment Company Act Release No. 11676 (Mar. 10, 1981) [46 FR 17012 (Mar. 17, 1981)]. The Commission amended rule 17a-7 in 1993 to provide boards with additional flexibility during their annual review of compliance procedures. See Investment Company Act Release No. 19719 (Sep. 17, 1993) [58 FR 49919 (Sep. 24, 1993)]. In 2005, the Commission amended rule 17a-7 to incorporate provisions specific to NMS stocks. See Exchange Act Release No. 51808 (Jun. 9, 2005) [70 FR 37496 (Jun. 29, 2005)].
[xii] See Valuation Rule Adopting Release, at n.6-7 and accompanying text.
[xiv] See also Alexander Eisele et al., Trading out of Sight: An Analysis of Cross-Trading in Mutual Fund Families, 135 J. Fin. Econ. 359 (2020).