INVESTMENT ADVISOR CONCEALS LOSSES AND GETS SANCTIONED

FROM:  SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission announced sanctions against a California-based investment adviser for concealing investor losses that resulted from a coding error and engaging in cross trading that favored some clients over others.

Western Asset Management Company, which is a subsidiary of Legg Mason, agreed to pay more than $21 million to settle the SEC’s charges as well as a related matter announced today by the U.S. Department of Labor.

According to an SEC order instituting settled administrative proceedings, Western Asset serves as an investment manager primarily to institutional clients, many of which are ERISA plans.  Western Asset breached its fiduciary duty by failing to disclose and promptly correct a coding error that caused the improper allocation of a restricted private investment to the accounts of nearly 100 ERISA clients.  The private investment that was off-limits to ERISA plans had plummeted in value by the time the coding error was discovered, and Western Asset had an obligation to reimburse clients for such losses under the terms of its error correction policy.  Instead, Western Asset failed to notify its ERISA clients until nearly two years later, long after the firm had liquidated the prohibited securities out of those client accounts.  

“When the coding error was discovered, Western Asset put its own interests above its clients and avoided telling investors what had caused losses in their accounts,” said Michele W. Layne, director of the SEC’s Los Angeles Regional Office.  “By concealing the error, Western Asset avoided reimbursing clients for their losses.”

In a separate order involving a different set of client accounts, the SEC finds that Western Asset engaged in a type of cross trading that was illegal.  Cross trading is the practice of moving a security from one client account to another without exposing the transaction to the market, and when done appropriately it can benefit both clients by avoiding market and execution costs.  However, cross trading also can pose substantial risks to clients due to the adviser’s inherent conflict of interest in obtaining best execution for both the buying and the selling client.

The SEC’s order finds that during the financial crisis, Western Asset was required to sell mortgage-backed securities and similar assets into a sharply declining market as registered investment companies and other clients sought account liquidations or were no longer eligible to hold these securities after rating agency downgrades.  Instead of selling the securities at prices that Western Asset believed did not represent their long-term value, it arranged for certain broker-dealers to purchase the securities from the Western Asset selling clients and sell the same security back to different Western Asset clients with greater risk tolerance in prearranged sale-and-repurchase cross trades.  Because Western Asset arranged to cross these securities at the bid price rather than a price representing an average between the bid and the ask price, the firm improperly allocated the full benefit of the market savings on the trades to buying clients and denied the selling clients approximately $6.2 million in savings.

“Cross trades serve a legitimate purpose and benefit both parties when done appropriately,” said Julie M. Riewe, co-chief of the SEC Enforcement Division’s Asset Management Unit.  “But by moving securities across client accounts in prearranged, dealer-interposed transactions, Western Asset unlawfully deprived its selling clients of their share of the savings.”

The SEC’s orders find that Western Asset violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7, and aided and abetted and caused violations of Sections 17(a)(1) and 17(a)(2) of the Investment Company Act of 1940.  Without admitting or denying the findings, the firm agreed to be censured and must cease and desist from committing or causing any further such violations.  For the disclosure violations related to the coding error, Western Asset must distribute more than $10 million to harmed clients and pay a $1 million penalty in the SEC settlement and a $1 million penalty in the Labor Department settlement.  For the cross trading violations, Western Asset must distribute more than $7.4 million to harmed clients and pay a $1 million penalty in the SEC settlement and a $607,717 penalty in the Labor Department settlement.  An independent compliance consultant must be retained to internally address both sets of violations.

The SEC’s investigation of the disclosure violations was conducted by Diana K. Tani and DoHoang T. Duong of the Los Angeles office.  An examination that led to the investigation was conducted by Charles Liao, Yanna Stoyanoff, and John Lamonica.  The SEC’s investigation of the cross trading violations was conducted by Asset Management Unit staff Valerie A. Szczepanik and Luke Fitzgerald of the New York office.  An examination identifying the cross trading issues was conducted by Margaret Jackson and Eric A. Whitman.  The SEC appreciates the assistance of the Labor Department and the Special Inspector General for the Troubled Asset Relief Program (SIGTARP), which assisted with the SEC and Labor Department investigations.