Friday, January 31, 2014

Fines Are Not Enough: Serial Settlements

Fines Are Not Enough: Serial Settlements

Western Asset Management settled two unrelated matters with the Securities and Exchange Commission and Department of Labor.  The fines and restitution came to $21 million, and as per usual, Western neither admitted nor denied the charges. Normally I wouldn’t write about these settlements, but they illustrate a major weakness in our regulatory system.  This isn’t the first time Western has settled with the SEC, and yet the regulator never mentions or takes into account the prior settlements or improprieties.  Moreover, it doesn’t appear that anyone in a senior position has been held responsible.  In both settlements, the SEC merely “sanctioned” Western.

I wrote about a securities fraud that occurred in a couple of high yield funds advised by Western in “Peering Beneath the Surface: Uncovering A Fraud (October 29, 2012).”  The portfolio manager was barred from the industry (and already had been terminated), and Western was charged with a failure to supervise.  However, no one was held individually accountable for the failure to supervise.  Western’s parent, Legg Mason, paid a $50,000 fine.[1]
 
Written Down (1999)
During the credit crisis, Western ran into a series of difficulties in its money market funds due to commercial paper investments issued by various structured investments.[2]  Legg Mason arranged financing to backstop the money market fund, and the SEC agreed to forego any enforcement action.[3]

In one of the recent settlements,[4] the SEC charged that Western miscoded a private security that led a trader to invest in an impermissible security on behalf of clients.  Even after Western discovered the mistake, it did not tell clients or reimburse them for the mistake (the security’s price fell sharply in the credit crisis).  The firm interpreted its policy regarding errors narrowly in order to avoid taking action. 

In the second action,[5] the SEC charged that Western inappropriately crossed a security between its clients.  An internal cross involves selling a security in one client’s portfolio and buying it in another portfolio.  While the practice is legal, it requires specific procedures and disclosures because there’s a huge potential conflict of interest involved in trading securities between clients.  On the other hand, if one client should legitimately be selling and another acquiring the security, it can save both clients money by not selling and then buying the security in the market.  For example, if client A only permits investment grade bonds in its account and client B permits non-investment grade investments, it might be perfectly acceptable to sell a bond that has been downgraded from A to B.

Unfortunately, Western made two mistakes.  First, it used the bid price, rather than the average of the bid and ask, so buyers always got the better end of the deal. Second, it crossed a security for a client that prohibited the practice.  In this case, the client was the U.S. Treasury.

Legg Mason’s spokesperson said, “Western Asset has always sought to meet a high standard of client and fiduciary standards and has redoubled its efforts over the past five years to address regulatory compliance and related matters, including the strengthening of controls in the areas covered by the settlements.”[6]

Back in 2001, Western made the same promises to the SEC in settling the securities fraud in the high yield funds.  In my view, these latest transgressions might have been avoided if the SEC held higher up executives responsible for these transgressions instead of simply settling on a fine.  Western will spend a lot of money on consultants and enhanced compliance procedures, but the culture won’t change. 

It’s culture and not compliance procedures that enable money managers to meet a high fiduciary standard.



[1] http://www.sec.gov/litigation/admin/ia-1980.htm
[2] http://www.nytimes.com/2008/03/08/business/08siv.html?dlbk
[3] http://www.sec.gov/divisions/investment/noaction/2008/leggmasonpartnersit102208-1.pdf
[4] http://www.sec.gov/litigation/admin/2014/ia-3763.pdf
[5] http://www.sec.gov/litigation/admin/2014/ia-3762.pdf
[6] http://www.reuters.com/article/2014/01/27/us-leggmason-settlement-idUSL2N0L114820140127

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