Crafting Effective and Compliant Policies and Procedures for Hedge Fund Managers Engaging in Cross Trades

Executing cross trades—transactions between two funds run by the same manager or between a hedge fund manager and its funds—sometimes can be more effective and cost-efficient for managers and investors than transactions executed with third parties. Although there are no legal prohibitions on such transactions, they are coextensive with certain conflicts of interests that must be managed. In particular, cross trades must be executed in accordance with managers’ fiduciary obligations, disclosures to regulators and investors, and compliance policies and procedures governing the transactions.

This article explains cross trades and identifies the common situations in which managers execute them, issues that arise in conducting a cross trade, necessary regulatory and investor disclosures, policies and procedures managers should implement to assure cross trades are properly executed and fair to both parties, and remedial steps managers should take in the event a cross trade is improperly executed.

There are three different types of trades that can be considered a cross trade: a trade between two funds run by the same manager; a principal transaction between a client fund and a fund in which the manager has a significant interest; and an agency trade in which an adviser or its affiliate acts as a broker on both sides of the transaction—both for the advisory client and for the counterparty—in addition to acting as an adviser and receives compensation for the brokerage activity.

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Bao Nguyen, a principal in the risk advisory services practice with Kaufman Rossin, added, “If a manager has an affiliated broker-dealer that wants to take a position in securities the fund is looking to liquidate, the broker-dealer would take on that position. That can be considered a cross trade because of the affiliation of the manager and the broker-dealer.”

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Cross trades can also occur when fund portfolios are rebalanced, said Plaze. Nguyen provided a hypothetical. “Let’s say two funds have a similar investment approach, and one fund has to reallocate and sell certain positions pursuant to the investment portfolio model. If those positions would be beneficial to the other fund, and there is a reduced cost to the selling fund, those positions could be cross-traded between the two funds, especially if it would be more expensive for the buying fund to buy those same securities on the open market.”

Nguyen added that cross trades can be advantageous for managers because they “basically allow a manager and its underlying funds to potentially reduce costs. They can be done as long as best execution is considered. Registered managers have best execution obligations to their clients, and these cross trades can potentially reduce the costs and fees of the transactions. However, when doing a cross trade, managers have to demonstrate that the purchase price was the best price for both clients giving all considerations to the trade.”

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“The SEC is concerned with cross trades because sometimes managers will want to take a position, perhaps a losing position, and move it to a certain fund to boost the return profile of the original fund,” noted Nguyen. “That’s a conflict, because what was done to benefit the investors in one fund hurt the investors in the other fund.”

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Nguyen explained the required Form ADV disclosures. “First, managers must disclose the ability to make cross trades to regulators in the Form ADV Part 1. Disclosures to investors are made via Form ADV Part 2A. Additionally, the operating agreements between the manager and the fund may include disclosures. Typically, the limited partnership agreements will disclose cross trades and policies and procedures relating to them as well. In addition, the manager is required to furnish a list of all cross trades to the fund on an annual basis.”

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Nguyen advised, “When a manager has a situation where it wants to do a cross trade, first and foremost, compliance needs to be involved. Compliance needs to look at why the trade is being done. You need to document a cross transaction and the reason why it was done. This is assuming that there is a written consent from the fund for such cross transaction. To the extent that a cross trade may impact a fund or even create an appearance of a conflict, there should be an investment committee involved, or at least the compliance officer, who can approve these transactions.”

To read the full article, visit the Hedge Fund Legal & Compliance Digest.