The SEC has proposed significant amendments to Rule 17a-7 under the Investment Company Act that would expand cross-trading opportunities for many registered funds, while enhancing compliance and oversight requirements. While much of the attention has focused on the proposal’s potential to reduce trading costs and improve execution, the changes have important implications for fund governance, compliance programs and audits.
Rule 17a-7 has historically allowed affiliated funds and accounts to trade securities directly with one another, provided they meet specific requirements. These cross-trades can reduce transaction costs, limit market impact and improve trading efficiency.
However, following the SEC’s adoption of Rule 2a-5, many fixed-income securities no longer qualified for cross-trade relief because they lacked “readily available market quotations.” As a result, many fund complexes lost the ability to cross trade a significant portion of their fixed-income portfolios under Rule 17a-7.
The SEC’s proposal restores much of that flexibility by allowing cross trades in many Level 2 securities, including corporate bonds and other fixed-income instruments that rely on observable market inputs for valuation. Level 3 investments remain ineligible. The proposal also excludes investments that are not categorized within the ASC 820 fair value hierarchy, including certain private fund-issued securities valued using the private fund’s NAV as a practical expedient. As a result, many interests in hedge, private equity, private credit and other private funds remain outside the scope of Rule 17a-7 cross-trading relief.
The proposal would:
The SEC estimates the proposal could generate approximately $173 million in annual transaction cost savings across the investment company industry.
For advisers, the proposal provides an opportunity to execute affiliated trades more efficiently, particularly within fixed-income strategies where transaction costs can be meaningful. However, the proposal also emphasizes demonstrating that cross-trades are executed fairly and in shareholders’ best interests. The SEC’s focus on adviser oversight and compliance testing reflects long-standing concerns regarding favoritism among accounts, inappropriate allocation practices and transactions that benefit one client at another’s expense.
The proposal reallocates certain oversight responsibilities from the board to advisers and chief compliance officers. Advisers would be responsible for making best interest determinations, while CCOs would perform quarterly reviews of cross-trading activity and annual testing designed to identify any abusive practices. The board’s role would shift toward overseeing the overall governance and compliance framework rather than directly monitoring transactions.
While the proposal is fundamentally a trading-rule modernization effort, it also has audit implications related to transaction eligibility, valuation, compliance oversight and related-party transaction testing. By expanding eligible securities, the proposal creates additional opportunities for affiliated cross-trade activity. Auditors will need to devote additional attention to identifying cross-trade populations, testing transaction eligibility and evaluating documentation supporting management’s conclusions.
The exclusion of Level 3 investments and private fund interests valued using the NAV practical expedient creates an important eligibility distinction that firms need to monitor closely. Fund complexes with interval funds, funds-of-funds, private credit investments or other private fund exposures should maintain controls to ensure ineligible investments are not inadvertently included in cross-trade populations.
The proposal places additional emphasis on valuation procedures. If firms elect to use current market prices from unaffiliated pricing sources, auditors will need to evaluate the reliability of those sources, test pricing methodologies and assess management’s controls over price verification. Because the proposal relies heavily on pricing-based safeguards, valuation and compliance testing are likely to become more interconnected than under the current framework.
The proposal also introduces other potential audit considerations, including the new compliance responsibilities for advisers and CCOs listed above. From a regulatory perspective, firms should expect continued scrutiny of affiliated transactions. Cross trades present inherent conflicts of interest, making documentation, oversight and consistent execution critical to demonstrating that all shareholders are treated fairly.
For auditors, the proposal moves cross-trade testing beyond a traditional related-party transaction exercise. Testing will increasingly involve valuation methodologies, compliance controls, pricing-source oversight, eligibility determinations and governance processes. Funds that adopt the expanded relief should expect auditors to spend more time understanding and testing the controls surrounding affiliated transactions.
The SEC’s proposal is less about creating an entirely new cross-trading regime and more about restoring flexibility many fund complexes lost after Rule 2a-5. If adopted, the amendments would give advisers an additional tool to reduce transaction costs and improve execution across affiliated accounts.
At the same time, the proposal reflects the SEC’s broader view that operational efficiency and investor protection can coexist, provided firms have robust governance, strong compliance oversight and well-documented controls around affiliated transactions.
For many advisers, the headline change is the return of cross-trading opportunities for a large segment of the fixed-income market. Just as important, however, is understanding what remains outside the rule. While many Level 2 fixed-income securities become eligible, Level 3 investments and certain private fund-issued securities valued using the NAV practical expedient remain excluded.
Advisers, fund boards, compliance professionals and auditors should focus not only on the opportunities created by the proposal, but also on the controls, valuation processes, compliance oversight, and documentation needed to support expanded cross-trading activity and demonstrate that affiliated transactions are executed in shareholders' best interests.
Contact Richard Wagner or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.