WAMCO Fine: A Coding Error or Compliance Breakdown?

A computer coding error.

That’s how most media outlets explained one of the key reasons the US Securities and Exchange Commission and the US Department of Labor whammied a large US fixed-income fund manager with a US$22 million fine.

The second is inappropriate cross-trading which unfairly benefited one group of clients at the expense of others. But it is the alleged technology glitch which is causing the most uproar — and for good reason. It went far beyond an understandable human error and surfaces a common scenario facing fund managers — what to do and not do when the wrong assets are allocated to a client, or individual fund account.

The settlement, which was offered by San Diego-headquartered Western Asset Management Company (WAMCO), and accepted by the SEC, was better than dealing with potential long-drawn and potentially costlier litigation. WAMCO agreed to a  censure and said that most of the fine would go to funds that were harmed by the fund manager’s apparent breach of its fiduciary responsibilities. As part of the settlement,WAMCO will also hire a compliance consultant to review its procedures and clean up its act.

Based on the SEC’s account and a brief statement from the DOL, WAMCO erroneously credited securities into ERISA-compliant funds. The subsidiary of Legg Mason added insult to injury by not immediately notifying the affected clients, including 99 US pension plans, and making them whole. Just how the entire saga unfolded indicates a series of technological blunders, lack of operational oversight, and questionable legal interpretations.

Fund managers reading the SEC and DOL’s documentation could stand to learn plenty. Naturally, they should already be aware of the technological and oversight controls they should put in place to fulfill their legal obligations to clients. Just in case they don’t, here are three key reminders highlighted by compliance and legal experts contacted by FinOps Report.

1. Ensure traders know and follow rules.

Approximately half the fine was related to cross-trading between 2007 and 2010 of securities in a manner that violated the Investment Company Act, ERISA and WAMCO’s own internal policies. The trades were also conducted in such a way that penalized half of the WAMCO clients involved. The trades were pre-arranged deals with counterparty dealers as sales at highest bid and immediate repurchase at markup, rather than the required practice of finding market value by averaging the highest ask and lowest bids. Because of the way the trades were conducted, the SEC found that the selling clients were unfairly penalized.

Compliance and control systems did not identify the pre-arranged trades, despite the identical spread on hundreds of trades. The non-compliance with trading rules was largely blamed on lack of supervision of a single trader. The SEC’s narrative highlighted that several attempts were made by WAMCO to educate the trading staff about cross-trading rules. Nonetheless, the bad trading practices continued.

2. Ensure correct configuration of compliance software.

The so-called coding error reflected a change made by a back-office staffer in the description of an asset class from asset-backed to corporate securities. Acting at the request of a portfolio compliance officer, the operations staffer input the new designation on February 1, 2007, the day after WAMCO first purchased a $50 million block of these private placement designed to provide subordinated debt to Hartford Insurance Group. Although market data identified the securities as corporate debt, the first page of the preliminary offering memorandum warned that the securities were to be sold only to “eligible purchasers,” defined to exclude ERISA-compliant funds.

What happened next is pretty mindboggling. The securities — now classified as corporate bonds — were automatically designated by WAMCO’s compliance module, licensed from Charles River Development, as ERISA-eligible. That meant they could be bought by pension plans following ERISA guidelines. But that change to ERISA eligibility was entirely wrong. The trader of the securities and others who might have known that the securities were not ERISA-eligible, were alerted to the change in classification, but raised no objections. The pension plans eventually paid for the purchase of US$90 million of these securities when they shouldn’t have.

As one of the US’ largest providers of order management and compliance systems, Charles River has distanced itself from any responsibility for the automatic re-designation of the securities as ERISA-eligible. “Charles River is not in a position to comment much on this situation,” says managing director Tom Driscoll in a e-mailed statement to FinOps Report. “The compliance system is only as good as the data that is fed into it and the accuracy of the compliance rules that are set up. In this case, the data and compliance rules set up by the users were not under our control. This is not due to a bug in the Charles River system.”

Five compliance specialists at US East Coast fund management shops contacted by FinOps Report agreed that fund managers do define the rules for how the portfolio compliance systems they use work, although they usually consult with the software firm. Linked to specific portfolios and portfolio types, such rules typically include the type of asset which can be purchased for each underlying account and what proportion of the total portfolio value it can comprise. If the compliance system operates on a pre-trade basis, as most do and the CRD system did, it is also supposed to prevent any erroneous trading by immediately notifying the portfolio manager and trader that a trade cannot be executed.

Allowing the CRD platform to automatically change the designation of the asset in question from ERISA-ineligible to ERISA-eligible without further intervention was a serious — and risky — error, according to a one compliance software specialist who spoke to FinOps on condition of anonymity. “The compliance software should have been coded to immediately prevent such an occurrence by requiring the data inputter to seek approval from a compliance specialist or at the very least making a conscious decision to populate the ERISA-eligible field,” says the C-level executive.

3. Disclose and fix mistakes immediately.

The compliance breach went undetected by WAMCO until more than a year later, and it wasn’t until 2010 that it notified the asset manager notified its clients. It’s hard to understand why WAMCO didn’t catch the erroneous designation of the securities or the allocation of what were still asset-backed securities earlier or why it didn’t fix the mistake immediately. WAMCO declined to answer questions about the delay emailed by FinOps Report.

Gary Swiman, a former compliance director at a large fund management shop and now head of the compliance and regulatory practice for New York financial services consultancy C&A Consulting, insists CRD’s system worked just fine — the way the client wanted it to. What concerns him the most is WAMCO’s lax operating controls. At least two other departments should have caught the erroneous US$90 million allocation — the compliance department and the portfolio manager in charge of ERISA accounts, he believes. “The amount of time that passed seems to suggest there is a gap in the portfolio management supervisory procedures related to the review of client accounts,” says Swiman. “In addition, the compliance department should have assessed the robustness of supervisory procedures, instead of just relying on output from the CRD system.” His stance is bolstered by the SEC’s interpretation of events.

WAMCO says it first became aware of the incorrect asset allocation on October 7, 2008 when it received an email from a former pension fund client. Apparently that client’s new fund manager discovered the ERISA-ineligible securities in the fund’s portfolio and reported they had declined significantly in value since their purchase in 2007.

Short for Employee Retirement Income Security Act of 1934, ERISA is administered by the DOL and governs the rigorous standards by which private corporate pension plans operate. Those standards call for advisers — or fund managers — to adhered to strict regulations regarding the types of assets they invest in. Fund managers breaching investment policies are compelled by ERISA rules to immediately inform the client and, if there are losses, make the client whole.

So what did WAMCO do? It apparently took the former client’s email so seriously that it conducted a three-month investigation into the matter. But what started off as a good idea, turned into legal mumble jumble. WAMCO decided that its mistake wasn’t really a mistake based on a “narrow legal interpretation” of its error policy — an opinion which several New York legal experts contacted by FinOps Report called “questionable and risky.” Still, WAMCO thought the holders of the securities might be “concerned,” according to the SEC’s report, so it attempted to sell them off. However, the price had fallen so low that there was no market for them. The result:  the asset-backed securities remained in the ERISA-compliant funds and the pension plans were not notified of the investment breach.

The securities were finally sold out of the funds between May and June 2009 at a price that was still well below the price paid — or the cost to the funds. It was these losses to ERISA and other funds, in addition to the losses to the selling funds in the illegal cross-trading that accounts for US$17.4 million of the entire fine. The rest is for penalties.

However large the fine appears at first glance it is probably little more than a slap on the wrist to the fund management giant with more US$451.5 billion under management as of the end of 2013. What is probably more threatening than the fine is the firm’s reputational damage. That kind of damage inevitably has financial implications.

The laws surrounding ERISA-compliant funds are designed to protect the interests of the beneficiaries of those funds and anyone involved with those fund are held to a far higher code of conduct than with any others. WAMCO’s compliance and error policies have already been updated by a consultant brought into the firm in May 2011, even before the $22 million settlement was reached.

A WAMCO spokeswoman in New York won’t elaborate on what steps her company has taken to avoid a repeat scenario, but insists that plenty has been done. “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,” says Mary Athridge. Those efforts, she adds, include the strengthening of controls in the areas covered by the settlement.

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