If you are a fund manager of more than one pooled investment vehicle, chances are, at some point, you will desire to "rebalance" the portfolios you manage to ensure that such vehicles have pro rata ownership of each securities position. Depending upon the facts and circumstances surrounding the pooled investment vehicles and the rebalancing transactions, however, the rebalancing transactions may be regarded as principal transactions. If the rebalancing transactions are regarded as principal transactions, you must provide your "client" with written disclosure of the transactions and receive "client" consent prior to the completion of such transactions. Such disclosure and consent requirements are designed to combat price manipulation, dumping of unwanted securities in client accounts and other forms of self-dealing. If the rebalancing transactions are not regarded as principal transactions, such transactions will still be regarded as cross trades.
Section 206(3) & No-Action Relief
Section 206(3) of the Investment Advisers Act of 1940, as amended (the "Advisers Act"), in pertinent part, prohibits any investment adviser, acting as principal for his own account, from knowingly selling or purchasing any security to or from a client without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. Because the anti-fraud provisions of Section 206 of the Advisers Act apply to unregistered investment advisers as well as registered investment advisers, the Securities and Exchange Commission ("SEC") may impose such restrictions on registered and unregistered investment advisers alike.
On numerous occasions, the staff of the SEC has stated that the determination of whether Section 206(3) applies to transactions involving accounts in which an investment adviser and/or its personnel have ownership interests depends upon all of the facts and circumstances. In a recent no-action letter, Gardner Russo & Gardner, dated June 7, 2006, the staff of the SEC provided more specific guidance with respect to Section 206(3)'s application to such transactions. In granting Gardner Russo & Gardner, an investment adviser to various client accounts including two private investment funds, no-action relief, the staff of the SEC stated that it believed that Section 206(3) would apply to a cross transaction between a client account and an account of which the investment adviser and/or a controlling person, in the aggregate, own(s) more than 25%. More importantly, however, the staff of the SEC stated that it did not believe that Section 206(3) would apply to a cross transaction between a client account and an account of which the investment adviser and/or its controlling persons, in the aggregate, own 25% or less.
Although the Gardner Russo & Gardner no-action letter provides useful guidance with respect to principal transactions in the context of rebalancing affiliated funds, the staff of the SEC still cautioned that a cross transaction involving an account in which an investment adviser and/or its controlling persons hold an ownership interest, even if less than 25%, still presents significant conflicts of interests. The staff went on to warn that provisions of the Advisers Act that impose fiduciary duties on an investment adviser with respect to its clients and a duty of full and fair disclosure of all material facts may still be implicated by any such transactions.
Disclosure & Acknowledgment
As noted above, transactions effected to rebalance portfolios that are managed by the same investment adviser, where the investment adviser and/or a controlling person, in the aggregate, own(s) more than 25% of one of the applicable portfolios, would be considered principal transactions and require client disclosure and consent. The disclosure and consent requirements apply prior to the completion of each principal transaction (i.e., each time you rebalance the portfolios). Blanket consents are not permitted. The disclosure provided to the client must be sufficient to identify and explain the potential conflicts of interests. Client consent may be obtained prior to the execution of the rebalancing transactions, or after execution but prior to settlement. The specificity of the required disclosure, however, may vary based upon whether consent is obtained prior to execution or after execution but prior to settlement.
Because pooled investment vehicles are considered the "client," in the context of rebalancing portfolios controlled, directly or indirectly, by the same persons that control the investment adviser, valid client consent may be difficult or impractical to obtain. Valid consent may be difficult or impractical to obtain because the persons effecting the principal transactions, who are subject to the conflicts of interests, are the same persons that ordinarily approve action on behalf of the portfolios. Although the SEC has provided little guidance in this context, fund managers may alleviate this inherent conflict by engaging independent third parties to review and approve the proposed rebalancing transactions and/or abiding by systematically applied written compliance policies and procedures adopted in advance of periodic portfolio rebalancing.
Even if portfolio rebalancing transactions are not deemed to be principal transactions, such transactions are still cross trades if effected among portfolios managed by the same investment adviser. As a result, registered investment advisers should describe any practice of periodic portfolio rebalancing on its Form ADV, and registered and unregistered investment advisers should describe any such practice (including any inherent conflicts of interests) in the offering documents of the applicable portfolios.
Rebalancing Affiliated Portfolios
Whether portfolio rebalancing transactions are deemed principal transactions or merely cross trades, it is particularly important that such transactions achieve "best execution" for the affiliated portfolios and that no portfolio is disadvantaged by the rebalancing transactions. Fund managers should strive to implement and thoroughly document an independent pricing mechanism (for example, quoted market prices) to achieve such goals. One mechanism used by fund managers to ensure "best execution" when rebalancing portfolios is to run the rebalancing transactions through the prime broker of the applicable portfolios at existing market prices. Many fund managers, however, choose to rebalance portfolios internally, which allows such managers and the applicable affiliated portfolios to avoid brokerage commissions and "mark ups" or "mark downs" that may be charged in open market transactions. Internal transactions also avoid market impact costs, and may result in reduced custody expenses and transfer taxes. When rebalancing portfolios internally, however, greater care must be taken to ensure "best execution" is achieved and properly documented.
Investment advisers that manage more than one pooled investment vehicle often desire to "rebalance" such portfolios to ensure that such vehicles have pro rata ownership of each securities position. Rebalancing transactions, however, whether effected in the open market or internally, may be considered principal transactions under applicable law and SEC guidance depending upon the facts and circumstances surrounding such transactions. In the event that such transactions are considered principal transactions, disclosure and client consent are required to combat self-dealing. In the context of affiliated funds, however, valid disclosure and client consent may be difficult or impractical to obtain. Even if the rebalancing transactions are not considered principal transactions, such transactions are still regarded as cross trades requiring "best execution" and full disclosure.
Published January 1, 2007.