February 13, 2014 — The investing public has a right to trust that investment advisor firms have their clients’ best interests in mind. When firms engage in illegal cross-trading schemes that favor one group of clients at the expense of another, however, that trust is broken. To protect the rights of investors to receive honest information and fair dealing from investment advisors that manage investors’ portfolios, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established a whistleblower program. Informants who collaborate with the U.S. Securities and Exchange Commission (SEC) about securities law violations may be rewarded for their willingness to notify the agency.
Western Asset Concealed Losses from Some Clients and Engaged in Illegal Cross-Trading with Others
The SEC has filed charges against a California investment adviser that hid investor losses caused by a coding error. Western Asset Management Company, a subsidiary of Legg Mason, has also been charged with cross trading that gave some clients preference over others. Western Asset will pay over $21 million to resolve those charges along with a related investigation by the U.S. Department of Labor.
Most of Western Asset’s clients are institutional clients, such as ERISA plans. According to the SEC, Western Asset breached its fiduciary duty as an investment manager by failing to notify its clients of a coding error that allowed a restricted private investment — off-limits to ERISA plans — to be allocated to the accounts of almost 100 ERISA clients. By the time Western Asset discovered the coding error, the prohibited private investment had tanked in value. Under the terms of Western Asset’s own error correction policy, the investment manager was obligated to reimburse the affected clients for their losses. Instead, the firm waited to inform clients for almost two years, by which time, the off-limits securities had been liquidated from the ERISA clients’ accounts.
What Is Illegal Cross-Trading?
Western Asset has also been charged with illegal cross-trading. Cross-trading occurs when a firm moves a security from the account of one client to the account of another firm client without going through the customary market transaction. Cross trading can save both clients money by eliminating the market and execution costs. But there are also risks involved, given the investment manager’s inherent conflict of interest associated with working both sides of the deal. It is illegal for an investment firm to favor one client over another in the process of cross-trading.
The SEC’s charges against Western Asset relate to cross-trading that occurred during the financial crisis. At the time, some of the firm’s clients were forced to sell mortgage-backed and other securities even though the market was sharply declining. Rather than sell the securities at unreasonably discounted prices, Western Asset negotiated with broker-dealers that would buy the securities from Western Asset’s selling clients and sell them back to Western Asset’s buying clients. Western Asset crossed the securities at the bid price, when it should have used an average between the bid and the ask price. As a result, Western Asset’s buying clients were greatly favored in the deal, as they received the full benefit of the trades, cheating selling clients out of $6.2 million.
To resolve the charges with the SEC and the Labor Department, Western Asset must pay a combined settlement that exceeds $21 million.
How to Collaborate with the SEC About Illegal Cross-Trading Operations
Insider employees with firsthand knowledge of illegal cross-trading should learn their rights before notifying the SEC. With offices in Los Angeles, Dallas and the Washington D.C. area, the SEC fraud lawyers at Waters & Kraus are committed to protecting whistleblowers’ interests in securities fraud cases. Contact us or call our qui tam lawyers at 855.784.0268 to discuss how we can assist you.