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US Securities and Exchange Commission

SEC Staff Asks for Comments on Ways to Enhance Rules on Investment Company Cross Trading

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

The SEC’s Division of Investment Management (IM) is asking the public for feedback about ways to enhance the regulatory regime governing investment company cross trading.  Cross trades are securities transactions between a fund and certain affiliates.

Rule 17a-7 of the Investment Company Act of 1940 allows cross trades under certain protective conditions. This means that transactions between a fund and another fund managed by the same investment adviser must meet the conditions in Rule 17a-7 unless the commission grants an exemption.

Among other conditions, cross trades should involve a security that has readily available market quotes, and the trades must be done at the current market price.  The SEC initially adopted Rule 17a-7 in 1966, and it has been revised a few times since then. But funds now invest in a greater variety of 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,” according to IM staff statement, published on March 11, 2021. “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.”

In December last year, the SEC adopted a rule to better reflect today’s fund fair valuation practices. In particular, it permits boards, subject to board oversight and other conditions, to designate certain parties to do the fair value determinations.

That rule also defines when market quotations are “readily available” and the threshold for determining whether a fund must fair value a security. A market quote is readily available when that quotation is a quoted price—or unadjusted price—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, according to Release No. IC-34128, Good Faith Determinations of Fair Value. (See SEC Updates Rules for Fund Valuation in the December 4, 2020, edition of Accounting & Compliance Alert.)

The staff statement said that when the SEC proposed the fund valuation rule in April 2020 in Release No. IC-33845, Good Faith Determination of Fair Value, the commission asked whether the proposed definition was appropriate and whether it would cause any compliance issues with any other provision of the federal securities laws.

A number of funds in comment letters responded that cross trades of certain fixed-income securities would not qualify as having readily available market quotes. The fund valuation rule’s compliance date is September 8, 2022. And as a result of the final rule, these funds will not have readily available prices after that date for those securities.

“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,” according to IM statement. “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.”

The staff said that feedback will be helpful when evaluating any recommendations it might make to the commission. In particular, the staff wants feedback on current cross trading practices; securities eligible to cross trade—pricing and liquidity; controls; and market transparency.

SEC Commissioner Elad Roisman welcomed the division’s effort. He said in a statement that the ability of funds to trade fixed incomes securities with their affiliates “were important concerns and remain so today.”

“I am grateful that the staff is moving forward in reviewing Rule 17a-7 and prioritizing questions related to fixed income in particular,” Roisman said. “This past year, we have all seen that our fixed income markets are critical to the functioning of our other securities markets and our economy more broadly.”

The IM statement has details about specific feedback the staff is seeking, including an appendix that outlines additional general topics that the staff will consider in making any recommendations to the commission. Feedback should be submitted to “IM-Rules@sec.gov” with “Cross Trading” in the subject line. The staff said it wants comments within 30 days.

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