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How to Turn an Error into an Enforcement Proceeding

A recent settlement involving coding errors and cross trades provides a case study of what notto do when issues and errors are identified internally. The investment adviser in question settled charges with the SEC and Department of Labor stemming from a coding error. This error caused ERISA clients to invest in securities where the issuer prohibited ERISA plans from investment. (More on the cross trades below.) The error occurred because the securities were marked in the adviser’s internal system as “ERISA eligible” when in fact they were not.

The charges appear to be more about how the firm acted when it discovered the coding error, as opposed to the error itself. This is often the case.

When the coding error was discovered, the adviser undertook a three-month internal review, but did not notify its clients at that time that they were invested in ineligible securities. The internal investigation included a review of whether the coding error was deemed an “error” for the purpose of the adviser’s error correction policy. If so, the firm was required to reimburse the clients for any losses they incurred as a result of the error. The firm concluded that the error in question did not require reimbursement under the policy. The firm also looked at client investment guidelines to see whether there were any breaches, and incorrectly concluded that none existed. (However, breaches were discovered during the SEC investigation.)

All of the adviser’s clients invested in the securities suffered substantial losses, as they sold their positions. It was not until a year after this that the adviser informed clients about the whole situation—and at that point, the adviser was aware that an SEC investigation was pending. The SEC press release can be found here.

How should you replay this situation?

First, the primary concern must be treating clients fairly, not protecting firm income.

Second, serious and comprehensive internal reviews should commence when an issue is discovered, not under threat of a regulatory investigation. (It may be that the adviser actually got this partially right.)

Third, notice to clients, fund boards (or governing bodies) and the regulators, even if not required, may be desirable. Those who do this will be cut some slack. On the other hand, failing to give notice can cut the other way: don’t expect a regulator to be pleased if it learns about a problem in the press.

The adviser in this case also settled other charges relating to improper cross trades. See the order here. While cross trades are permissible in some circumstances, here they disadvantaged clients. Whenever an adviser effectuates cross trades or principal trades appropriately documenting the rationale behind the trade determination can be helpful, if not critical. But again, the take away is that the SEC is looking to make sure that clients are treated fairly and in accordance with the adviser’s fiduciary duty.

How to turn an error into an enforcement proceeding? Put firm profits above client interests and try to cover up the error.

Said differently: mistakes happen. Don’t blow them out of proportion because of what your firm does when they are discovered. Put clients’ interests first and shed light onto troublesome areas. However difficult this may appear to be at the time, it is a lot less difficult, time consuming, and expensive than dealing with an enforcement proceeding.

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