SEC Charges Investment Adviser With Improper Conduct in Two Proceedings

by Dorsey & Whitney LLP

The Commission filed two settled administrative proceedings involving Western Asset Management Co., a subsidiary of Legg Mason, Inc. One centered on the failure of the firm to promptly disclose to clients that a coding error resulted in the improper allocation of a restricted security to the accounts of almost 100 ERISA clients. In the Matter of Western Asset Management Co., File No. 3-15689 (Jan. 27, 2014)(“Western I”). The second involved improper cross-trades. In the Matter of Western Asset Management, Co., Adm. Proc. File No. 3-15688 (Jan. 27, 2014)(“Western II”).

Western Management is a registered investment adviser. The firm provides advisory services primarily to corporations, municipalities and other governmental entities and pension and profit sharing plans, In Western I, from 2007 through 2009 the firm disclosed to clients in its form ADV that its general policy was to make a client account whole for any net loss associated with a breach or error. Errors, according to the policy, included those from regulatory requirements and restrictions, client mandates and operational restrictions. They also included those from trading and settlement.

In January 2007 the firm purchased $50 million of the initial offering of Glen Meadow, a $500 million private placement. The preliminary prospectus stated that an eligible purchaser excluded employee benefit plans subject to ERISA.

Through a coding error Western Asset’s automated compliance system, relied on to ensure compliance with restrictions regarding the type of securities that could be acquired for various accounts, incorrectly stated that the Glen Meadow securities were ERISA eligible. In October 2008 the firm learned from an email sent by a former institutional client that the Glen Meadow securities were not ERISA eligible. Western Asset identified the accounts impacted but did not notify the clients. The firm did, however, launch a three-month investigation. It concluded that there was an error but not within the meaning of the correction policy. The inquiry also determined that there was no violation of ERISA, although there could be liability to the issuer for violating the terms of the offering.

By year end a firm committee reviewed the situation. It concluded that there had not been a guideline breach or an ERISA prohibited transaction. There was no discussion of any obligation to notify clients under the error correction policy. Subsequently, the firm sold all the Glen Meadow at prices materially lower than the purchase price. The clients were not notified.

The Order alleges that the firm violated Advisers Act Sections 206(2) and 206(4). The firm should have promptly disclosed the error to clients no later than December 2008, according to the Order. The firm also failed to have adequate compliance policies and procedures requiring the notification of clients. Here the firm avoided implicating its error correction policy by adopting a narrow definition of the term error.

Western Assets resolved the matter. The firm agreed to implement a series of undertakings which include paying to the effected ERISA clients $9,620,392. That amount represents approximately the sum by which the clients were impacted. The firm will also retain an independent compliance consultant who will review the policies and procedures. Western Assets will adopt the recommendations contained in the consultant’s report. In addition, the firm consented to the entry of a cease and desist order based on the Sections cited in the order and to a censure. It also agreed to pay disgorgement of $8,111,582, prejudgment interest and a civil money penalty of $1 million.

Western II centers on improper cross trades that took place from 2007 through 2010. Generally, Sections 17(a)(1) and (2) of the Investment Company Act prohibit any affiliated person of a registered investment company from knowingly selling a security to, or purchasing a security from, the investment company absent first obtaining an order from the Commission. Excluded from the prohibition are affiliations arising solely because the two have a common investment adviser or common directors or officers if certain requirements are met. Those include that the cross trade be executed in accord with the method for determining the current market price under Rule 17a-7. ERISA also prohibits investment advisers from engaging in cross trades unless certain criteria are met. Western Asset has internal policies, disclosed to its clients, largely prohibiting cross trades except in limited circumstances.

Throughout the financial crisis, Western Asset’s clients demanded account liquidations. Those required the firm to sell non-agency mortgaged back securities and similar assets in a declining market. The firm frequently sought to repurchase those securities for other clients. In its dealings with most counterparties, the sale and repurchase were separate arms-length transactions.

In a number of instances, however, the firm engaged in unlawful cross trades. Specifically, Western Asset engaged in pre-arranged trades through a dealers’ representative. Under that arrangement the dealer would purchase securities from Western Asset’s selling clients and then resell the same securities to the purchasing clients. The firm did not seek an order from the Commission permitting the transactions. By interposing the dealer, the firm caused the affected client accounts to engage in prohibited cross trades. The transactions also violated ERISA.

The cross-trades involving the dealer also were not priced in accord with Rule 17a-7. Rather, the sale transactions were executed at the highest current independent bid and the repurchase transactions at a small prearranged markup over the sale price. Under this method one client was favored over another with the full benefit allocated to the buying clients. By not exposing the cross trades to the market Western Asset saved market costs of about $12.4 million. The selling clients were deprived of their share of the market saving, about $6.2 million. During the period the firm’s compliance systems and controls failed to identify the impermissible cross trading.

The Order alleges violations of Sections 17(a)(1) and (2) of the Investment Company Act as well as Sections 206(2) and 206(4) of the Advisers Act.

The firm resolved the proceeding after effecting certain remedial acts which the Commission considered in determining to accept the offer of settlement. Those include the retention of a consultant and an undertaking to adopt the recommendations of that consultant. Respondent also agreed to distribute $7,440,881 to compensate certain impacted clients. In addition, Western Asset consented to the entry of a cease and desist order based on Sections cited in the Order and to a censure. The firm will also pay a civil money penalty of $1 million.


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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