SEC Brings Enforcement Action Involving Improper Trade Allocations and Cross Trades

February 6, 2014

The SEC sanctioned Western Asset Management Company (“Western Asset”), which is a subsidiary of Legg Mason, for concealing investor losses that resulted from a coding error and engaging in cross trading that favored some clients over others. According to the SEC, 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.

In a separate order involving a different set of client accounts, the SEC found 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 SEC found that 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.

Reference Documents:  Western Asset Management - IA-3762 - 1-27-2014 (cross trades)

                                         Western Asset Management - IA-3763 - 1-27-2014 (trade allocation)

Subjects:  Cross Trades

                  Aggregation and Allocation

How To:    Trading Operations