Financial Services Alert - February 11, 2014 February 11, 2014
In This Issue

Goodwin Procter Alert: The Alternative Investment Fund Managers Directive – Status Update of Implementation Throughout Europe

Glynn Barwick in the firm’s London office has provided an update on progress made by the EU Member States in implementing the Alternative Investment Fund Managers Directive.  The Update features a chart highlighting the most important issues for fund investors and outlining the regulatory requirements for each country.

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

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).

SEC Staff Issues Risk Alert Addressing Adviser Due Diligence on Alternative Investments

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Examination  Program Risk Alert that summarizes OCIE staff observations on investment adviser due diligence practices with respect to alternative investments.  The alternative investments considered for this purpose were principally private funds such as (a) hedge, private equity, venture capital and real estate funds and (b) funds of private funds.  The Risk Alert catalogs the observations of OCIE staff in terms of (1) industry due diligence practices, (2) red flags in the due diligence process and (3) Advisers Act compliance issues with respect  to alternative investment due diligence.   As a preliminary matter, the Risk Alert notes that an adviser that exercises discretion to purchase alternative investments on behalf of its clients, or that relies on an underlying manager of an alternative investment to perform due diligence, must determine whether such investments: (i) meet the client investment objectives; and (ii) are consistent with the investment principles and strategies that were disclosed by the underlying manager to the adviser (as set forth in various documents, such as advisory disclosure documents, private offering memoranda, prospectuses, or other offering materials provided by the underlying manager).

Due Diligence Practices.  Most of the Risk Alert is devoted to a discussion of industry practices.  The Risk Alert does not make specific recommendations, but does highlight the following practices as ones that “may provide greater transparency and that independently support the information provided by underlying managers:

  1. the use of separate accounts to gain full transparency and control;
  2. the use of transparency reports issued by independent fund administrators and risk aggregators;
  3. the verification of relationships with critical service providers; 
  4. the confirmation of existence of assets;
  5. routinely conducting onsite reviews;
  6. the increased emphasis on operational due diligence; and
  7. having independent providers conduct comprehensive background checks.”

Deficiencies.  The OCIE staff identified the following material deficiencies or control weaknesses in examinations of advisers recommending alternative investments:

  • failure to include due diligence for alternative investments in the annual compliance review when these types of investments are a “key portion” of an adviser’s business;
  • discrepancies between the disclosures regarding due diligence practices made to clients and prospective clients and the due diligence performed; and
  • failure to comply with the requirement under Advisers Act Rule 204‑2(a)(13)(iii) to maintain a record of (i) decisions to permit advisory personnel to acquire securities in a limited offering as defined under Advisers Act Rule 204A-1, and (ii) the reasons supporting those decisions.

The Risk Alert states that while many of the advisers examined by the staff had written formal due diligence procedures or guidance, these procedures were typically not incorporated into the advisers’ compliance manuals, and those that did not have formal written procedures, at a minimum, had some type of informal due diligence framework in place.  The Risk Alert further comments that advisers whose written policies and procedures were detailed and required adequate documentation were more likely to have consistently applied due diligence processes.  The Risk Alert also observes that advisers that delegated responsibilities to third-party service providers, but did not conduct periodic reviews of service provider performance, were more likely to have deficiencies in meeting those responsibilities.

SEC Further Extends Securities Law Exemptions for Security-Based Swaps

The SEC adopted amendments to the expiration dates of certain interim final rules adopted in July 2011 (that were described in the July 5, 2011 Financial Services Alert).  The interim final rules provide exemptions under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Trust Indenture Act of 1939 to security-based swaps that were security-based swap agreements prior to the effective date of Title VII of the Dodd-Frank Act.  Because the Dodd-Frank Act defines security-based swap agreements as “securities,” such instruments would have become subject to various requirements applicable to securities in the absence of the interim final rules.  The interim final rules, however, generally exempt such instruments from the requirements of the relevant statutes, other than certain anti-fraud provisions.  The interim final rules were originally scheduled to expire on February 11, 2013.  The expiration dates were previously extended to February 11, 2014 (as described in the February 12, 2013 Financial Services Alert).  The latest amendments further extend the expiration dates to February 11, 2017. 

Mutual Fund Directors Forum Issues Report on Director Oversight of Mutual Funds Focused on Non-Traditional Assets and Strategies

The Mutual Fund Directors Forum issued a report designed to provide practical guidance to mutual fund directors about overseeing “alternative funds.”  The report treats as an “alternative fund” any registered open-end fund that uses non-traditional assets or strategies to a significant degree.For this purpose, non-traditional assets include derivatives, structured securities, metals, hedge funds or commodities, while non-traditional strategies include managed volatility, risk parity, absolute return, long-short, hedged debt, market-neutral and managed futures strategies.  (The report notes that while they may face similar issues, it does not address closed-end funds.).  In broad terms, the report highlights key considerations for boards in establishing and overseeing an alternative fund, including (a) the investment and operational capabilities of the adviser, service provider expertise and resources, and the suitability of the alternative asset class/strategy for the mutual fund regulatory and tax environment; (b) for a subadviser-managed alternative fund, the subadviser’s experience in the registered fund environment, due diligence and ongoing oversight by the primary adviser, fee arrangements, and allocation of responsibility between the primary adviser and the subadviser; (c) evaluation of performance, including use of custom benchmarks and identification of appropriate peer groups, if any; and (d) prospectus disclosure.

FRB Governor Tarullo Outlines Top Regulatory Priorities for 2014

In testimony before the Senate Banking Committee on February 6, FRB Governor Daniel Tarullo set forth the FRB’s top regulatory priorities for 2014.  While Governor Tarullo noted the recent progress in implementing the mandates in the Dodd-Frank Act, he also highlighted the areas necessitating greater work, including the “problems of ‘too-big-to-fail’ and systemic risk.”

Overviewing progress on a number of Dodd-Frank reforms, Governor Tarullo first discussed a proposed rule issued by the FRB and other Federal banking agencies in October 2013, which aims to create the first broadly applicable quantitative liquidity requirement for U.S. banking firms (the “Proposed Liquidity Rule”) (which was discussed in the October 29, 2013 Financial Services Alert).  Governor Tarullo stated that the Proposed Liquidity Rule is more stringent than the international standard proposed by the Basel Committee in the range of assets that will qualify as high-quality liquid assets and the assumed rate of outflows for certain kinds of funding.  He also reported that the Proposed Liquidity Rule is on an accelerated phase-in period that is shorter than the Basel Committee’s standard.

Governor Tarullo also discussed several proposed rules that the FRB expects will be finalized in the near term.  He stated that proposed rules for enhanced prudential standards for large U.S. and foreign banking firms with total global consolidated assets of $50 billion or more will be finalized shortly, and will include liquidity requirements, risk-management requirements, single-counterparty credit limits, and an early remediation regime.  Governor Tarullo further noted that Federal banking agencies expect to strengthen the Basel III supplemental leverage ratio in the coming months.  This would require bank holding companies with more than $700 billion in consolidated total assets, or $10 trillion in assets under custody, to maintain a Tier 1 capital leverage buffer of at least 2 percent above the minimum Basel III supplementary leverage ratio requirement of 3 percent, for a total of 5 percent.  Governor Tarullo also stated that the orderly liquidation authority proposed rule is a key priority.  He noted that the FRB is currently consulting with the FDIC on a proposal that would require the largest, most complex U.S. banks to maintain a minimum amount of long-term unsecured debt outstanding at the holding company level.  He stated that the FRB believes that while minimum capital requirements help to cover losses, if a troubled large institution’s failure is imminent, successful resolution without taxpayer assistance would be best achieved if the institution has sufficient, long-term, unsecured debt to absorb additional losses and to recapitalize the business transferred to a bridge operating company.

Governor Tarullo also discussed the risks from the “shadow banking” system as well as the FRB’s expectations regarding information security at financial institutions.