SEC and DOL Reach $21 Million Settlement with Adviser Over Alleged Failure to Disclose and Correct Trading Errors and Improper Cross-Trading

by Goodwin

The Securities and Exchange Commission (the “SEC”) and Department of Labor (“DOL”) reached settlements with Western Asset Management (the “Adviser”), a registered investment adviser and subsidiary of Legg Mason Inc., under which the Adviser agreed to pay approximately $21 million related to determinations by the SEC and DOL that the Adviser (a) had purchased ineligible securities for clients subject to the Employee Retirement Income Security Act of 1974 (“ERISA” and such clients, “ERISA Clients”), (b) had failed to promptly notify the ERISA Clients of, and correct, these trading errors in accordance with the Adviser’s error correction policies, and (c) had separately engaged in improper cross trades.  The settlements conclude four years of SEC and DOL investigations.  This article provides selected highlights of SEC and DOL findings against the Adviser, principally as set forth in the two SEC orders formally settling public administrative proceedings against the Adviser relating to these matters.  The Adviser has neither admitted nor denied the regulators’ findings.

Settlements Regarding Ineligible Securities and Error Correction

Purchase of Pass-Through Trust Certificates

The SEC and DOL settlements related to alleged trade errors involving purchases of privately-placed Pass-Through Trust Certificates (the “Certificates”) by the Adviser for various client accounts.  The Adviser ultimately purchased $204 million of the Certificates for 233 client accounts, including more than $90 million for 99 ERISA Clients. 

The alleged trading errors with respect to the Certificates were traced to the manner in which compliance personnel coded the Certificates in the Adviser’s automated compliance system.  The Adviser’s compliance personnel ran trades through this system prior to allocating them to client accounts; any trade inconsistent with the limitations coded in the system for a client would be rejected before it could be allocated to the client account.  The SEC order notes that compliance personnel used information from outside providers like Bloomberg and from the Adviser’s trading desk to define the characteristics of a new security in the compliance system, but did not “independently review any offering documents.”  Market data providers characterized the Certificates as a corporate security.  Offering documents for the Certificates provided to the Adviser stated that employee benefit plans subject to ERISA were not eligible to purchase them.

The Certificates were initially coded in the Adviser’s compliance system as an asset-backed security that was not eligible for ERISA Clients.  On February 1, 2007, the day after the first purchase of $50 million of the Certificates for client accounts, a portfolio compliance officer, following up on an exception report from an overnight compliance run, caused the security type for the Certificates in the compliance system to be changed from “asset-backed security” to “corporate debt.”  Because of the compliance system’s design, this change in security type automatically re-designated the Certificates as permissible for ERISA Clients. 

Discovery of the Error and Response

On October 7, 2008, a former client notified the Adviser that the Certificate was not appropriate for ERISA Clients.  The Adviser re-designated the Certificate in its compliance system as ineligible for ERISA Clients and began an investigation.  In December 2008, the Adviser’s committee responsible for overseeing the resolution of possible investment compliance issues (the “Compliance Committee”) concluded, based on the internal investigation and legal analysis from inside and outside counsel, that there had been no guideline breaches and no “prohibited transaction” under ERISA at the time of purchase, but that the Adviser might have potential exposure to the issuer of the Certificates for breaching the terms of the offering.  The Adviser explored selling the Certificates held by ERISA Clients in February and March 2009 but took no action because of deterioration in the price of the Certificates.  The Adviser ultimately sold all positions in the Certificates held by ERISA Clients and other client accounts between May and June 2009 at prices materially lower than their purchase prices.  The Adviser did not notify the ERISA Clients that it had purchased the Certificates for their accounts until August 2010.

Error Correction Policy

The Adviser maintained an error correction policy as part of its compliance program, which was described in the Form ADV provided to clients at the outset of the client relationship.  As set forth in the Adviser’s Form ADV from 2007 through 2009, this policy provided that the Adviser’s “general policy, except where contractual arrangement or regulatory requirements provide otherwise, is (i) to make a client account whole for any net loss associated with a breach or an error [and] (ii) to retain in a client’s account, a net gain resulting from an error.”  The Form ADV disclosure further provided that “if breach or error occurs in a client portfolio, it is [the Adviser’s] policy that the error will be corrected immediately or, in the case of guideline breaches, the client will be immediately be [sic] contacted to obtain a waiver.  If a waiver is declined, the error will be promptly corrected. If the breach, after correction, results in a gain to the client, that gain is retained in the client portfolio. If the client suffers a loss as a result of the breach, [the Adviser] will reimburse the account.”

In response to the October 2008 communication from the former client regarding the Certificates, the Adviser’s compliance staff conducted an investigation whose ultimate conclusion was that there had been no error within the meaning of the Adviser’s error correction policy.  The investigation focused on whether there had been a violation of ERISA and whether any client guidelines had been breached, and involved the use of key word searches of client guidelines to determine whether any of the affected ERISA Clients had guidelines forbidding investment in ERISA ineligible securities.  The SEC found that these key word searches failed to uncover applicable guidelines for two accounts belonging to one client, and also failed to discover a guideline breach unrelated to ERISA for a second client.  In connection with its deliberations regarding possible guideline breaches and ERISA prohibited transactions, the Compliance Committee did not discuss whether the Adviser had any obligation to notify clients of the allocation error under the terms of its error correction policy. 


The SEC found that “[b]y negligently buying [the Certificates] for certain of its ERISA clients, delaying disclosure of its error and failing to promptly reimburse its clients” the Adviser willfully violated the prohibition in Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”) against engaging in “a transaction, practice or course of business which operated as a fraud or deceit upon its clients.”  The SEC also found that the Adviser violated the Adviser Act compliance program requirements of Rule 206(4)-7 by “failing to implement policies and procedures reasonably designed to ensure that errors and breaches are promptly corrected and disclosed to affected clients,” citing in particular the Adviser’s application of “narrow definition of the term ‘error’ under its error correction policy.”


The Adviser has undertaken to make a distribution to affected ERISA Clients of approximately $10,000,000.  In addition to censure and a cease-and-desist order, the Adviser agreed to engage a compliance consultant and to pay civil penalties of $1 million each of the SEC and DOL.

The SEC acknowledged remedial acts undertaken by the Adviser and cooperation afforded to the SEC staff as factors in its settlement with the Adviser.  

Settlements Regarding Cross Trades

Cross Trade Activity in Response to the Financial Crisis

The SEC and DOL settlements relating to cross trades between the Adviser’s client accounts focused on transactions in non-agency mortgage-backed securities and similar assets during the financial crisis.  These transactions resulted from client demands for account liquidations and rating agency downgrades that caused securities to become ineligible under client account guidelines.  Believing that these securities represented good long-term investments, the Adviser sought to place them with other clients for whom it believed them suitable.  The SEC found that in most instances the sale and the repurchase were separate arms-length transactions.  However, in the transactions that were the subject of the settlements, the SEC and DOL determined that the Adviser prearranged with dealers to execute the sell side of the cross trade at the highest current independent bid available for the securities, and execute the buy side at the sale price plus a small prearranged markup designed to compensate the dealers for administrative and other costs incurred.   The SEC found that by executing cross trades in this manner during the period January 2007 through approximately April 2010, the Adviser avoided market costs of approximately $12.4 million, but because it used the bid price it allocated the full benefit of these savings to the buying clients in the cross trades and deprived the selling clients of their share of the savings, representing approximately $6.2 million.  Among the client accounts involved in these cross trades were registered investment companies (the “Funds”) and ERISA Clients. 

Investment Company Restrictions on Cross Trades

Under Sections 17(a)(1) and 17(a)(2) of the Investment Company Act of 1940 (the “1940 Act”), any affiliated person of a registered fund, or any affiliated person of such affiliated person, acting as principal, generally may not knowingly sell a security to, or purchase a security from, the fund unless the SEC provides exemptive relief or the transaction complies with Rule 17a-7 under the 1940 Act. (The SEC order notes that under the anti-evasion provisions of the 1940 Act, interposing a dealer does not avoid the prohibitions of Section 17(a).)  The SEC found that the dealer-interposed cross trades among the Funds and other Adviser clients were subject to Section 17(a)’s prohibitions, and that the Adviser failed to obtain specific exemptive relief or comply with the conditions of Rule 17a-7, in particular the requirements under Rule 17a-7 that (a) a cross trade be executed at the “independent current market price for the security,” which, for most bonds, is defined as “the average of the highest current independent bid and lowest current independent offer, determined on the basis of reasonable inquiry,” and (b) no brokerage commission (aside from customary transfer fees) or other remuneration be paid in connection with a cross trade.

ERISA Restrictions on Cross Trades

Section 406(b)(2) of ERISA prohibits investment advisers like the Adviser, as fiduciaries, from engaging in cross trades for ERISA clients unless a prohibited transaction exemption is available, which was not the case for the subject cross trades involving ERISA Clients.

Compliance Policies Governing Cross Trades

The Adviser’s compliance manuals prohibited cross trades involving ERISA Clients, and permitted cross trades involving Funds only in compliance with Rule 17a-7.  The Adviser’s compliance group was supposed to preapprove each cross trade.  The SEC found that the Adviser did not devote sufficient resources to monitoring cross trades and that it did not properly supervise the trader charged with overseeing cross trades who ignored red flags suggesting violations of the Adviser’s policies. 

Additional Violations

In addition to the violations of Section 17(a) of the 1940 Act and Section 406(b)(2) of ERISA noted above, the SEC found that the Adviser (a) violated Section 206(2) of the Advisers Act by allocating the full market savings in the dealer-interposed cross trades to the buying clients, (b) failed to meet the compliance program requirements of Advisers Act Rule 206(4)-7, (c) violated Section 207 of the Advisers Act through disclosures regarding its cross trade policies made in the Adviser’s Form ADV filings, and (d) failed to reasonably supervise within the meaning of Section 203(e)(6) of the Advisers Act the trader overseeing cross trades.


In addition to censure and a cease-and-desist order, the Adviser agreed to (1) make a distribution to the affected ERISA Clients and Funds in the amount of $7,440,881, representing the benefit they would have received had the Adviser executed those transactions at the mid-point price, plus reasonable interest, (2) pay civil penalties of $1 million to the SEC and $600,000 to the DOL, and (3) engage a compliance consultant. 

The SEC acknowledged remedial acts undertaken by the Adviser and cooperation afforded to the SEC staff as factors in its settlement with the Adviser.   

In the Matter of Western Asset Management Company, SEC Rel. No. 33-3763 (January 27, 2014)(trading errors).

In the Matter of Western Asset Management Company, SEC Rel. No. 33-3762 (January 27, 2014) (cross trades).

Department of Labor Release Number: 14-0113-NAT (January 27, 2104).

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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