US stock market daily report (January 27, 2014, Monday)
January 28, 2014, Tuesday, 05:02 GMT | 00:02 EST | 09:32 IST | 12:02 SGT
Western Asset Management Company, a subsidiary of Legg Mason Inc. (LM-NYSE), agreed to pay more than $21 million to settle Securities and Exchange Commission charges that the California-based investment adviser concealed investor losses resulting from a coding error and engaged in cross trading that favored certain clients over others. Western Asset also faces sanctions as a related matter announced by the U.S. Department of Labor. Michele Wein Layne, director of the SEC’s Los Angeles Regional Office said, “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. By concealing the error, Western Asset avoided reimbursing clients for their losses.”
Western Asset serves as an investment manager primarily to institutional clients, many of which are ERISA plans, according to an SEC order instituting settled administrative proceedings. 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, Western Asset breached its fiduciary duty. By the time the coding error was discovered, the private investment that was off-limits to ERISA plans had plummeted in value and Western Asset had an obligation to reimburse clients for such losses under the terms of its error correction policy. 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.
The SEC also finds that Western Asset engaged in a type of illegal cross trading, in a separate order involving a different set of client accounts. Cross trading is the practice of moving a security from one client account to another without exposing the transaction to the market. When done appropriately, cross trading can benefit both clients by avoiding market and execution costs. Cross trading can pose substantial risks to clients due to the adviser’s inherent conflict of interest in obtaining best execution for both the buying and selling client.
During the financial crisis, per the SEC’s order, Western Asset was required to sell mortgage-backed securities and similar assets into a sharply declining market as registered investment companies as well as other clients sought account liquidations or were no longer eligible to hold these securities after rating agency downgrades. Western Asset arranged for certain broker-dealers to purchase the securities from their selling clients and sell the same security back to different clients of theirs, with greater risk tolerance in prearranged sale-and-repurchase cross trades instead of selling the securities at prices they believed did not represent their long-term value. 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 when 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.
Julie M. Riewe, co-chief of the SEC Enforcement Division’s Asset Management Unit said, “Cross trades serve a legitimate purpose and benefit both parties when done appropriately. 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.”
Per the SEC’s orders, Western Asset violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7, plus aided, abetted and caused violations of Sections 17(a)(1) and 17(a)(2) of the Investment Company Act of 1940. Western Asset agreed to be censured and must cease and desist from committing or causing any further such violations, without admitting or denying SEC findings.
Western Asset must distribute over $10 million to harmed clients, must pay a $1 million penalty in the SEC settlement and pay a $1 million penalty in the Labor Department settlement for the disclosure violations related to the coding error. 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, for the cross trading violations. Additionally, an independent compliance consultant must be retained by Western Asset to internally address both sets of violations.