Gary DeWaal's Bridging the Week: January 27 to 31, and February 3, 2014 (Computer Glitches, Employee Raid Aftermath, and a CCO Suspension)

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Published Date : February 03, 2014

Last week, many in the world celebrated the lunar New Year and the arrival of the "Year of the Horse." However, there were no celebrations at two large financial service firms when complex computer systems they daily relied on for compliance with regulatory obligations turned out to be Trojan horses. This was because coding issues made these computer systems produce reports that looked accurate but in fact contained incomplete or inaccurate information that caused the firms significant regulatory headaches, including large fines.

As a result, the following matters are covered on this week's Gary DeWaal's Bridging the Week:

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Computer Coding Errors Result in Fines for Two SEC Registrants

Both Scottrade, Inc., a broker dealer, and Western Asset Management Company, an investment advisor, settled enforcement actions with the US Securities and Exchange Commission last week related to rule violations that initially derived from computer system coding errors.


In its enforcement action against Scottrade, the SEC charged the firm with violating its record keeping obligations. This is because the Firm failed to provide the SEC complete and accurate information in response to requests for information related to possible law violations (blue sheet requests).

In 2003, Scottrade instituted a new back office processing system to store and provide information to the SEC and self-regulatory organizations in response to blue sheet requests. In March 2006, the Firm implemented a code change to this program. However, this code change inadvertently caused Scottrade not to report to the Commission on 1,231 occasions certain types of trades from March 2006 through April 2012. The problematic trades were trades that had been transferred from Scottrade's customers' to its own error accounts because the trades resulted from trading errors or had been deemed fraudulent.

The SEC acknowledged that this error was not intentional and that Scottrade's Information Systems Department had conducted tests of the data processing system after the coding change, and that the Compliance Department annually tested samples of blue sheet responses, but both departments failed to discover the problem.

For its violations, Scottrade agreed to pay a fine of US $2.5 Million and retain an independent consultant to assess the adequacy of, and make recommendations regarding, the Firm's policies and procedures regarding blue sheet submissions.

Western Asset Management

In the other computer coding incident, Western Asset Management Company (WAM) was charged by the SEC with various violations of the Investment Advisers Act, including a prohibition against fraud and a requirement that managers maintain policies and procedures to avoid violations of law.

WAM's offense related to the initial allocation of securities from a private placement to accounts of various retirement plans subject to the Employee Retirement Security Act, contrary to offering restrictions by the issuer. WAM did not take prompt action to correct its mistake, nor notify the affected retirement plans until months after it liquidated the securities from their accounts.

After WAM purchased US $50 Million of the relevant private placement in early 2007, a WAM compliance officer made change regarding the nature of the issuer's security on the Firm's automatic compliance system. However, this change automatically changed the designation of the security to "ERISA eligible," when in fact it was not. Thereafter, WAM continued to purchase the relevant issuer's security for its customers' accounts, including more than US $90 Million worth of the private issue for 99 ERISA accounts. More than a year later, WAM recognized its error; however, it did not liquidate the security or notify the relevant accounts until almost two years after the initial incident. Moreover, it did not reimburse the ERISA accounts for losses sustained as a result of the liquidation.

In connection with its settlement, WAM agreed to pay US $10 Million to harmed clients, a US $1 Million fine to the SEC, and a US $1 Million fine to the Department of Labor in connection with a separate enforcement action brought regarding the same matter. WAM is a subsidiary of Legg Mason, Inc.

In an unrelated action, WAM also agreed to pay impacted clients US $7.4 Million, a US $1 Million fine to the SEC, and more than US $600,000 to the Department of Labor, for engaging in prohibited cross trade transactions.

In this other matter, the SEC alleged that WAM, on behalf of various clients, including ERISA clients, sold certain mortgage-backed securities and similar assets into a declining market from 2007 through 2010. However, WAM had arranged for certain broker-dealers to buy these securities and sell them back to other WAM clients with greater risk tolerance. These transactions were done as cross trades at the bid price, rather than at an average price in between the bid and ask, providing the new purchasing clients with the full benefit of the cross, while the selling clients were harmed. However, WAM owed a fiduciary duty to both its selling and buying clients.

In additions to paying restitution and a fine, WAM also must hire a compliance consultant to conduct a follow-up review of certain recommendations made by a remedial consultant related to WAM's systems and controls related to cross trades.

Compliance Weeds: Once again, changes to software and data entry have caused issues with firms' computer systems that caused inadvertent compliance issues that the firms were unable to self detect promptly. This should again remind firms that:

  1. periodically, tests on computer systems to emulate regulatory requests should be conducted to ensure that the production is as anticipated.
  2. output generated by new or amended software should be reviewed carefully following roll-out to ensure it is producing data as anticipated; and
  3. no change to computer software should be implemented without following the procedure for rolling out new software;
  4. no new computer software should be implemented without a comprehensive consideration and testing of such system prior to roll-out, in a robust test environment, to ensure (a) full compliance with all applicable regulatory requirements and (b) no impact on other systems' compliance with all applicable regulatory requirements.

All testing should be documented in writing and include the sign-off of appropriate Compliance and IT staff.

State Street UK Fined GB £22.9 Million (US $37.9 Million) by UK Financial Conduct Authority for Deliberately Charging Clients More Than Agreed Management Fees or Commissions

In connection with its transition management services, State Street Bank Europe Limited and State Street Global Markets International Limited (collectively State Street UK) were fined GB £22.9 Million (US $37.9 Million) by the UK Financial Conduct Authority for developing and executing, "a deliberate and targeted strategy to charge substantial mark-ups on certain transitions, in addition to the agreed management fee or commission, that were deliberately not agreed with clients or disclosed to them." As a result, six customers were overcharged over US $20 Million as a result of transitions undertaken on their behalf between June 2010 and September 2011.

Transition management services involve carrying out structural changes to asset portfolios on a client's behalf. TM clients at State Street UK are typically large investment management firms or asset owners (including pension fund trustees) holding pension funds or savings on behalf of retail investors.

FCA claimed that, during the relevant period, State Street UK failed to take "reasonable care" to ensure that relevant documentation, the trading process, or communications with clients were adequately monitored. The FCA attributed this to the State Street's "matrix management framework."

Apparently, after an individual client identified certain non-agreed mark-ups on certain trades, the management of the group directly overseeing this business claimed the mistaken mark-up was inadvertent and paid a substantial rebate on that basis for those trades only. However, the managers failed to disclose the existence of other improper mark-ups to the same client, State Street UK Compliance, or State Street UK senior management. Subsequently, managers outside the group raised concerns and an internal investigation was conducted, problems found, and rebates or offers of rebates provided to all impacted customers.

In agreeing to the fine with State Street UK, the FCA gave the Firm credit for implementing its own "comprehensive remediation program, at its own initiative" to resolve this matter with its clients and to enhance its control environment.

And briefly:

And even more briefly:

Fore more details, see:

ASIC Enforceable Undertaking with BNP Paribas:$file/028399392.pdf.

CFTC MAT Confirmation for MarketAxess SEF:
ESMA Proposes Conditional Equivalent Determination for Japan CCPs:
CFTC Scheduled Hearings:

DMO (Packaged Transactions):
Global Markets' Advisory Committee:
Technology Advisory Committee:

FCA: Final Notice re: Anthony Verrier:
FCA: Final Notice re: State Street UK:
FINRA: Banorte-Ixe Securities International, Ltd:
ICE Clear Credit Cash and Collateral Fees Proposal:
NFA Clarifies Who May Submit Comments for NFA's CTA/CPO Capital Requirements and Customer Protection Measures Request for Comments:
SEC Alternative Investments Due Diligence Processes:
SEC Computer Coding Enforcement Actions:

Western Asset Management:

See Department of Labor Press Release Regarding These Matters:

Speech by Benoit Coeure Risks in Central Clearing Counterparties:

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of February 1, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.

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