Principal Trading

Problems with the SEC Rule

A principal trade is a securities transaction between an asset manager and a client account over which the manager exercises discretion. Such trades can be advantageous to a client in situations where its manager either is the only available counterparty to a transaction or can save the client a market spread or brokerage commission by dealing with the client directly. It is not uncommon for such situations to arise when managers open, close or rebalance discretionary accounts, especially where fixed income securities are involved (since such instruments typically trade on a principal basis).

The SEC prohibits managers from buying or selling securities from or to their discretionary accounts without obtaining client consent to such transactions before they settle. In seeking such consent, managers are also required to provide clients with details of the proposed principal trades in writing.

Clearly, the SEC rule is intended to prevent asset managers from gouging their clients, and it makes perfect sense from an ethical standpoint. Unfortunately, the rule ignores the basis of the relationship between the parties.

Clients hire and pay discretionary managers to make their investment decisions for them, so they do not ordinarily expect to be asked by their managers to approve particular trades. On the contrary, since they have entrusted them with their investment assets, clients would expect their managers to engage in principal trading only when it would be clearly to the clients’ economic advantage, since the managers would be violating their fiduciary duties to their clients if they were to do otherwise.

Moreover, the consent sought by a manager for a proposed principal trade is often a mere chimera in view of the fact that the client typically has nothing on which to base its consent to a principal trade other than the recommendation of the manager. A client could consult a third-party for an objective evaluation of a proposed principal trade, but the cost of that advice would probably neutralize the economic advantage of the trade.

Given the underlying inconsistencies between the SEC rule and client expectations, it’s no wonder that managers may balk at engaging in principal trades even when they view them as economically advantageous to their clients. Those managers who do engage in this activity must believe that their principal trades are demonstrably to their clients’ advantage or they must assume the risk of later regulatory sanction if their client consents are obtained fraudulently.

In either case, what’s the point of requiring advance consent?