The Securities and Exchange Commission sanctioned an investment adviser for allowing some of its ERISA plan clients to invest in private placements, even though the issuer specifically restricted investments by ERISA plans.  In a January 27, 2014 order instituting administrative and cease-and-desist proceedings, the SEC alleged that the adviser violated its error correction policies by failing to immediately correct the breach.

Due to a coding error at the time of purchase, the adviser’s compliance system classified the investment as ERISA eligible, when in fact it was not.  Neither the portfolio compliance staff nor the trader recognized that the security was not eligible for ERISA accounts.  In the following months, the adviser placed $90 million par value of the issue in 99 ERISA client accounts.

Upon learning of the error more than 18 months later, the adviser corrected the compliance coding fields from ERISA eligible to ERISA ineligible.  After a three- month internal investigation, the adviser concluded that there were no guideline breaches and no “prohibited transactions,” but that the adviser might have potential exposure to the issuer for breaching the terms of the offering.   The adviser did not notify its ERISA clients of the improper allocation at this time, because it concluded that no breach of client guidelines had occurred.

More than two years after purchasing the securities, the adviser sold the entire position at prices materially lower than the purchase prices for all of its clients.  The SEC said that before executing the sales, the adviser neither informed its ERISA clients that it had improperly allocated the security to their accounts, nor did it advise them of its error upon the sale of the security.  More than one year later, after the adviser was aware of the SEC investigation, it notified its clients of the error.

The SEC charged the adviser with violating the general anti-fraud provisions (Section 206(2)) of the Investment Advisers Act of 1940.  It also charged the adviser with violating Section 206(4) of the Advisers Act and Rule 206(4)-7 for failing to adhere to its compliance policies and procedures.  The SEC noted that the adviser’s compliance policies required the adviser to promptly notify its clients of any breaches or errors resulting in a loss, and to make clients whole for such losses.  The SEC disagreed with the adviser’s assertion that the adviser’s narrow interpretation of its guidelines did not require such a notification.

Without admitting or denying the allegations, the adviser agreed to

  • pay its affected ERISA clients compensation of approximately $9.6 million;
  • hire an independent compliance consultant to conduct a comprehensive review of the adviser’s supervisory and compliance policies and procedures designed to resolve allocation and coding errors;
  • pay a $1 million civil fine; and
  • a censure.

This case, which involved a complicated set of facts, demonstrates that the SEC examination staff will dig deep into the facts when it believes it has identified compliance violations.  It also underscores a recurrent theme: the SEC takes seriously any failure to adhere to compliance policies.  In this case, the adviser narrowly interpreted its compliance policies and procedures to conclude that no violation had occurred.  The SEC disagreed, and effectively sanctioned the adviser for not taking a more expansive view of its compliance responsibilities.