These FAQs are part of a series of frequently asked questions that address four primary areas of interest to investment advisers:
- Compliance Program Components;
- Daily Operations;
- Client Protection; and
- Registration and Disclosure
Explanation of Terms
Q1: What is trade aggregation?
A1: Trade aggregation is the process of adding together trade orders to purchase and sell the same security as one large order. Investment advisers frequently aggregate orders for administrative convenience and to achieve lower overall execution costs/commission rates typically associated with larger orders.
Q2: Is trade aggregation the same as bunching or blocking trade orders?
A2: Yes. All three terms (aggregation, bunching, blocking) can be used interchangeably.
Q3: What is a partial fill of an aggregated trade order?
A3: A partial fill is execution of less than the full amount of a trade order. When a partial fill occurs, an investment adviser must allocate the purchased securities or sale proceeds among the participating accounts in a manner different from the original order.
Q4: What is trade allocation?
A4: When an investment adviser aggregates a trade order, the order must be allocated to the various accounts/clients participating in the aggregated trade.
Aggregation and Allocation Requirements
Q5: What are the rules for aggregating a trade order?
A5: While there is no specific rule under the Investment Advisers Act of 1940 (“Advisers Act”) regarding the aggregation of trade orders, the SEC has addressed the issue through various No-Action Letters. The SEC has stated that the aggregation of client orders does not violate the anti-fraud provisions of the Advisers Act if (i) the practice of aggregating orders is fully disclosed in the adviser’s Form ADV and separately disclosed to existing clients, (ii) no advisory account, including a proprietary account, is favored over any other account and (iii) each client who participates in an aggregated order does so at the average share price, with all other transaction costs shared on a pro rata basis.
Q6: What are the rules for allocating a trade order?
A6: As with trade aggregation, neither the Advisers Act nor the rules under the Advisers Act address the allocation of trade orders. However, this does not mean that the SEC has not made its expectations for investment advisers in this area clear. These expectations fall into three categories: (i) fairness to clients (e.g., if the order executed at different prices, an investment adviser must ensure the trades are fairly allocated to avoid one client or group of clients consistently benefiting over another); (ii) adequate disclosures (e.g., an investment adviser must disclose in the Part 2 of Form ADV the fact it may aggregate trades, and their procedures for handling these trades); and (iii) adequate trade allocation policies and procedures (e.g., having a specific and systematic method of allocating trade orders).
Q7: What are some examples of adequate trade allocation policies and procedures?
A7: The SEC staff has stated that the following trade allocation procedures would be acceptable:
- The investment adviser must prepare, prior to entering an aggregated order, a written statement (the “Allocation Statement”) specifying the participating client accounts and how it intends to allocate the order among those clients.
- If the aggregated order is filled in its entirety, it will be allocated among clients in accordance with the Allocation Statement.
- If the aggregated order is 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 advisory firm’s chief 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 investment adviser’s books and records separately reflect, for each client account, the orders which are aggregated, and the securities which are held, bought or sold.
- 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 is necessary to settle the purchase or sale in question on a delivery versus payment basis. Cash or securities held, collectively, for clients will be delivered out to the custodian bank or broker-dealer as soon as practicable following the settlement.
- The investment adviser will receive no additional compensation or remuneration of any kind as a result of the proposed aggregation.
- Individual investment advice and treatment will be accorded to each advisory client.
Record Keeping Requirements
Q8: What books and records is an investment adviser required to keep with respect to trade aggregation and allocation?
A8: Pursuant to Advisers Act Rule 204-2(a)(3), a registered investment adviser is required to keep:
“A memorandum of each order given by the investment adviser for the purchase or sale of any security, of any instruction received by the investment adviser concerning the purchase, sale, receipt or delivery of a particular security, and of any modification or cancellation of any such order or instruction. Such memoranda shall show the terms and conditions of the order, instruction, modification or cancellation; shall identify the person connected with the investment adviser who recommended the transaction to the client and the person who placed such order; and shall show the account for which entered, the date of entry, and the bank, broker or dealer by or through whom executed where appropriate. Orders entered pursuant to the exercise of discretionary power shall be so designated.”
Q9: What are some books and records guidelines with respect to trade orders and allocations?
A9: The following guidelines may assist investment advisers in keeping valid books and records with respect to trade orders and allocations:
- For each trade order, an investment adviser should keep accurate order memoranda that reflects all applicable information required by Advisers Act Rule 204-2(a)(3);
- The trade order ticket for an aggregated order should reflect the allocation determination at the time of the order;
- The trade order ticket should indicate the allocation methodology used and any deviations from the advisory firm’s standard method of allocating trade orders and include the reason for any such deviation; and
- The trade order ticket should reflect all modifications or cancellations of trade orders or allocations made at any time.
Q10: What books and records pertaining to trade aggregation and allocation will the SEC request prior to an examination?
A10: The Staff of the SEC may request some or all of the following documents and information pertaining to trade aggregation and allocation:
- A description of the process for monitoring block trades;
- A list of the names and titles of the individuals who are authorized to reallocate transactions and describe the circumstances that would arrant the reallocations; and
- A list of any reallocation/post settlement allocations made during the examination period.
Q11: What is the most common methodology used by investment advisers for allocating trade orders?
A11: Investment advisers typically allocate trades pro rata based on client assets under management.
Q12: Is an investment adviser permitted to deviate from the advisory firm’s stated method of allocating trade orders?
A12: Yes. For example, there may be situations when an allocation based on client size may not be practical or may not allow the portfolio manager to address particular client investment objectives. However, it is essential that any deviation from the advisory firm’s standard method of allocating trades be fully documented including the methodology actually used and the reason for the deviation.
Q13: Is as investment adviser allowed to include the accounts of related persons (e.g., employees, family) and/or proprietary accounts (e.g., accounts held by the advisory firm) in an aggregated trade order?
A13: Yes. However, in the event of a partial fill of the order, if the portfolio manager deviates from the advisory firm’s stated allocation methodology, related and proprietary accounts should not be filled until all client accounts have received the appropriate allocation.
Q14: What is cherry-picking?
A14: Cherry-picking involves delaying an allocation of securities until after the order is filled and the transaction price has been determined. It also may be when an order is reallocated at the end of the day once the trade price has been established. Cherry-picking allows an advisory firm to allocate a disproportionately greater percentage of favorable or unfavorable trades to one account over another. Cherry-picking is a clear violation of an investment adviser’s fiduciary duty.
Q15: What questions should an investment adviser ask when reviewing their trade allocation practices?
A15: The SEC expects investment advisers to ask the following questions:
- Are allocations of limited investment opportunities (e.g., hot IPOs) dispersed among clients in ways that fairly reflect clients’ investment objectives and restrictions, disclosures made to clients, and your fiduciary relationship with clients?
- Are allocations among clients of positions acquired in blocked or bunched trades consistent with disclosures and your fiduciary relationship with clients?
- Are proprietary accounts’ and access persons’ participation in investment opportunities, including blocked or bunched trades, consistent with your code of ethics, and disclosures made to clients? Also, are any staff issued interpretive guidance, such as no-action letters, applicable?
- When changes are made to the initial decisions regarding the allocation of trades among client, proprietary, and/or access persons’ accounts, are these changes supported by fully documented and approved audit trails?
- If the allocation of block orders among clients or proprietary accounts is determined at any time after an order is placed for execution, is the allocation, including the selection of accounts to participate in such trades, consistent with disclosures and your status as a fiduciary?
Q16: What questions does the SEC expect an investment adviser to ask when reviewing their trade allocation disclosures?
A16: The SEC expects investment advisers to ask the following questions:
- Are disclosures regarding trade allocation policies and procedures, including possible exceptions to the use of these policies and procedures, consistent with your actual practices?
- Do disclosures of trade allocation policies and procedures, including possible exceptions to the use of these policies and procedures, fully and fairly inform clients of your practices and enable clients to give their informed consent to all material conflicts of interest that may arise?