SEC Accuses Legg Mason of Some Accidental Fraud

This is pretty much the most boring securities fraud ever, so, you are warned.

"SEC Charges Legg Mason Affiliate With Defrauding Clients" is a pretty juicy headline as these things go. Legg Mason is a big deal and the affiliate, Western Asset Management Company, is a big deal all on its own, with $442.7 billion in assets under management. And they agreed to a $21 million settlement, which is like nine hours' worth of JPMorgan settlements, so that's pretty big I guess.

But the alleged fraud was ... oh is it boring. Actually there were two alleged frauds. (Both boring!) The first one, which cost Legg Mason more than $10 million, is literally that employees hit the wrong button in their compliance database. In January 2007, Wamco bought for its clients $50 million worth of Glen Meadow, "a $500 million private placement that was designed to provide subordinated debt financing to the Hartford Insurance Group." The offering memorandum said that the securities could not be sold to Employee Retirement Income Security Act benefits plans, because there are rules about what sorts of things Erisa benefits plans can own, but those rules are too boring to discuss in polite company. 1 Then this happened:

Glen Meadow was initially coded in WAM's automated compliance system as an asset-backed security that was non-ERISA eligible. On February 1, 2007, a portfolio compliance officer, following up on an exception report from an overnight compliance run, directed WAM's back office staff to change the security type from "asset-backed security" to "corporate debt." Charles River, however, had been configured so that slightly different fields appeared on screen depending on whether the security was designated asset-backed or corporate debt. Changing the designation of Glen Meadow from asset-backed to corporate debt resulted in Charles River automatically populating this field as ERISA eligible without any user input.

They filled out a database wrong because "slightly different fields appeared on screen." ("Charles River" is for some reason the name of the database.) I understand that financial fraud is having a big pop-cultural moment these days, what with the "Wolf of Wall Street" movie, and I'm hoping that Hollywood next turns its attention to this story. The riveting drama of a database automatically populating a field as Erisa-eligible without any user input sounds can't-miss to me.

Freed from Erisa constraints by mis-coding, they went and bought more Glen Meadow, ultimately putting more than $90 million of it into Erisa accounts. Finally, in October 2008, a former client told them about the error and Wamco sprung into action:

Initially, upon learning of the coding error, WAM compliance staff changed the ERISA field in Charles River from ERISA eligible to ERISA ineligible.

Good start!

Even though WAM had promptly identified the affected accounts, it did not immediately correct the error or notify clients. WAM's compliance staff instead completed an internal portfolio breach compliance report to document the issue reported by the Former Client.

Oh. Okay. You gotta be sure you know what happened before rushing to change things or alarming clients unnecessarily. Document the issue quickly, then fix it.

WAM then launched a three-month investigation into the matter.

Well that ... that is not especially quick. But when you finished investigating you told the clients?

Although WAM concluded there had been no guideline breaches or ERISA prohibited transaction affecting its clients, it realized that its ERISA clients might still be concerned. As a result, WAM explored selling the Glen Meadow position out of all ERISA accounts in February and March 2009. This effort met with little success.

Ehhhhh. Also "WAM did not notify its ERISA clients that it had erroneously purchased the Glen Meadow security for their accounts until August 2010, by which time WAM was aware of the SEC investigation."

Eventually they sold the stuff, in May and June 2009, at a loss to the clients of around $8 million, or around 10 percent. 2 That loss, by the way, was caused by market moves, not coding errors: Prices for subordinated insurance debt that may or may not have been asset-backed looked rather different in 2007 and 2009. But, sure, if not for the coding error, Wamco's Erisa clients would have been in different, Erisa-eligible securities that would probably have lost just as much money? More? But more legally? I don't know.

Anyway, this violated some rules, and if you are really into Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder you can read all about them here, you sicko.

I'll move right along to the other SEC complaint, which was, they had some clients who had to sell some bonds, and they had other clients for whom they wanted to buy those same bonds:

Throughout the financial crisis, as Western's clients demanded account liquidations and as rating agency downgrades caused certain securities to be ineligible for certain of its client accounts, Western was required to sell non-agency mortgaged backed securities and similar assets into a sharply declining market. Believing that these securities represented good long-term investments for other clients, Western frequently sought to repurchase for those other clients the same securities it was required to sell.

But it looks weird if you do that without a price check: How do you decide what price the one client sells at and the other buys at? So Wamco dutifully went off and sold the bonds to independent dealers at whatever price the dealer bid, then bought them back for its buyer clients at whatever price the dealers offered:

In its dealings with most counterparties, the sale and the repurchase were separate arms-length transactions.

But sometimes apparently they weren't:

In its dealings with several other counterparty dealers, however, Western engaged in unlawful cross trades by entering into prearranged sale and repurchase transactions. Specifically, prior to the sale transactions, Western and the dealers' representatives formed an agreement or understanding that the dealer would purchase securities from Western's selling client account and then sell the same securities to Western's purchasing client account.

That's pretty easy work for the dealers, so they didn't get paid very much for doing it. 3 The default approach in which "the sale and the repurchase were separate arms-length transactions" would mean that clients would in effect pay the full bid/offer spread just so that Wamco could blamelessly move bonds between their accounts. Instead, the clients paid only a tiny administrative spread. That was good for clients! It was just better for some clients than for others:

By avoiding exposing the cross traded securities to the market, Western saved market costs totaling approximately $12.4 million, but, because Western arranged to cross the securities at the bid price, it allocated the full benefit of these savings to its buying clients. As a result, Western deprived its affected selling clients of their share of the market savings, an amount totaling approximately $6.2 million.

Note that, if they'd just done arm's-length market transactions, those selling clients also would have sold at the bid, and would have been deprived of the $6.2 million just the same.

But what they did seems to have violated a bunch of rules. There is some mention of Section 17(a)(1) and 17(a)(2) of the Investment Company Act, and Sections 206(2) and (4) of the Advisers Act also trundle ominously into view. I cannot assure you that "rules thereunder" don't make an appearance. Again you are free to read the order if that's the sort of thing you're into, I will try not to judge.

You can go ahead and judge Wamco (which neither admits nor denies, you know the drill). They did bad, now they pay. Not a big deal, as these things go, but a $21 million deal anyway. You gotta type the right things into the right fields in your compliance database! That is definitely a thing. You gotta do your cross-trading in the right way, not the wrong way. 4 If they messed up, they should fix it and pay off their clients and so forth.

But I guess it's worth saying a couple of other things. One is that the rules here are genuine client-protection rules, intended to keep investment advisers from deceiving their clients and self-dealing with client money. Another is that nothing that the SEC says Wamco did was intended to, or did, hurt clients: It (presumably) bought the Glen Meadow bonds for clients in good faith, didn't sell them in a dislocated market, and ended up selling them in a more normalized market -- at a loss, but at a loss not inconsistent with the experience of similarly junior ABS-ish insurance-industry bonds from 2007 to 2009, and in any case not caused by this Erisa nonsense. And doing the cross-trading wrong, as opposed to right, saved buying clients $12 million while costing selling clients roughly zero. (Doing it wrong, or right, in both cases involved selling at the bid; doing it right would also involve buying at the ask.)

That's not a reason not to enforce the law, of course. But you get a good sense of the sheer boring complexity of the law from these accusations. The cross-trading stuff is a series of traps, and the Erisa stuff ... I mean, there's a reason they have an outsourced database to keep track of what can be sold to which clients. The reason is that no human could keep track of it. And while, yes, in hindsight, in an SEC order, you look like a bunch of doofuses for doing a three-month investigation of how you hit the wrong button in a database, instead of just telling clients and fixing the problem, it's sort of understandable. Certainly I can't tell from the SEC order if any Erisa rules were violated, or if Wamco's clients were at risk for any terribleness (legal liability, rescission of trades -- which would've been a good thing, in the event, or zeroing out of their bonds) because they bought no-Erisa things in yes-Erisa accounts. Because it's complicated! It's no huge surprise that it took them three months.

People get pretty worked up about the complexity of financial regulation. Mostly I don't get it: You kind of need complicated regulations to regulate complicated things. 5 But still, it's interesting to see that complexity in action here -- not in anything super high-stakes and dramatic and systematically important, but just in the guts of getting a big organization to comply with a set of rules that no single person could comprehend. You need to outsource your comprehension to computers, and then you need a three-month investigation to comprehend your computers. Wamco's efforts to figure out their compliance apparently made it harder for them to do the right thing for their clients. That's not exactly what you want out of your compliance program.

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  1. Even down here we'll talk in whispers and leave a lot to the imagination. The basic idea is that Erisa plans -- pensions, mostly -- have high fiduciary standards, and onerous related-party-transaction rules, designed to prevent administrators from ripping off beneficiaries. These standards apply to "plan assets," and the concept of "plan assets" looks through certain types of ownership. So you have duties not only with respect to the stocks and bonds you own, but also sometimes with respect to all the stuff owned by the companies whose stocks you own, and so forth. These rules are gray and unclear and can monkey with the underlying business, so lots of instruments just contain terms saying "no Erisa plan can own this stuff," to avoid problematic restrictions. Here is a law firm memo. Here are memos on asset-backed securities and Erisa. Here is one notorious private placement memo for an asset-backed thingy; note in particular the ALL-CAPS language on page 110, requiring purchasers of Issuer Notes to warrant that they are not Erisa plans and won't sell to Erisa plans.

  2. They're paying $9.6 million of restitution for this bit, which "represents an approximation of the amount by which such clients were impacted as a result of the conduct set forth in this Order, plus reasonable interest." (Later the order breaks it down as $8.1 million of disgorgement and $1.5 million of interest.) There's also a $1 million civil money penalty. So $8.1 million on $90 million par is about 9 points of par, though I don't know what prices they bought at. (All of the $90 million was bought in the aftermarket, in 2007 and maybe 2008.)

  3. "Western began engaging in prearranged cross transactions no later than January 2007, and it effected 88 cross transactions during 2007 with the dealers. Western executed the sale transactions at the highest current independent bid available for the securities, and executed the repurchase transactions at a small prearranged markup over the sale price. For example, in 2007, all but 1 of the 88 repurchases were effected at an identical markup over the sale price of just 0.03125% of the par value of the security, or, in bond parlance, a ½ 'tick.' In the eight-month period September 2009 through April 2010, Western caused its client accounts to engage in 108 prearranged sale and repurchase transactions, and 96% of these repurchases were effected at a 2 'tick' spread over the sale price. Western paid the markup to compensate the dealers for the administrative and other costs they incurred in connection with the transactions."

  4. Seems like you can do cross trades without paying a broker if you do it at the mids. (See Rule 17a-7.) Why did Wamco pay a broker and do it at more or less the bid? I don't know. The rules for doing it internally at the mids are pretty annoying; I don't know if that played a role.

  5. Or simple principles, but that's not really on offer.

(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)

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Matthew S Levine at

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