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NEW YORK (Thomson Reuters Regulatory Intelligence) - It’s the second enforcement case in two months involving the risky practice of cross trading, Putnam Investment Management, LLC and one of its former portfolio managers have settled Securities and Exchange Commission (SEC) charges related to “dozens of prearranged cross trades between advisory client accounts in a manner that disadvantaged some of the adviser’s clients,” the SEC said.

Traders work on the floor of the New York Stock Exchange in this April 1, 2008 file photo.
Although the September 27 case involving Putnam{here} has subtle differences from another recent crossing case involving Hamlin Capital{here}, which was announced in August, the regulator has signaled its continuing scrutiny over cross trades, in which investment advisers sell securities directly from one account to another.

The inclusion of the Putnam portfolio manager involved in the case and his suspension also sends a strong message of personal liability and deterrence.

Below is a summary of the alleged missteps at Putnam, and suggestions for managing the highly scrutinized practice of cross trading.

A common challenge faced by traders is executing buy and sell orders at favorable prices without affecting prices, due to the size of the orders. In large, actively traded securities, the task is simple. Things get messy and thus riskier, when less actively-traded securities such as non-agency residential mortgage-backed securities (RMBS) are the security involved.

Another challenge is when one account or group of accounts must sell or liquidate a position, while a portfolio manager is willing, or wishes to buy more of the same security for other accounts. Engaging in crossing can open a firm to several problems. On the surface, crossing may appear beneficial to both accounts. However, the reasons and specifics surrounding the cross often raise red flags.

The SEC has been closely scrutinizing these crosses in exams and inspections, often resulting in deficiency letters or enforcement actions. Both the Putnam and Hamlin Capital cases resulted in penalties and disgorgement greater than $1 million.

According to the SEC’s order, Putnam and the former portfolio manager of Putnam’s structured credit group, Zachary Harrison, prearranged cross trades in RMBS that favored some clients over others. The SEC alleged that between April 2011 and September 2015, “Harrison prearranged with broker-dealers to temporarily sell the securities and repurchase them at a small mark-up, usually the next business day.”

The SEC said, “Harrison’s conduct caused Putnam to prearrange dealer-interposed cross trades in which trading counterparties purchased fixed income securities from certain Putnam advisory accounts and then resold the securities to other Putnam advisory accounts.” Most of the cross trades involved registered investment companies or affiliates.

The SEC said, “Putnam did not adopt and implement policies and procedures reasonably designed to prevent unlawful cross trading, failed reasonably to supervise Harrison, and filed Forms ADV with the Commission that contained untrue statements of material fact and omitted to state material facts required to be stated therein.”

The SEC order also faulted Putnam's compliance department. It said that in early 2014, an SEC enforcement action against Western Asset Management{here} raised concerns at Putnam as it highlighted the risk of cross trading. "...the compliance department determined to schedule a training session addressing such conduct; however, no such training occurred during the relevant period," the order said.

Harrison disclosed certain details of his conduct in mid-2016, the SEC said. Putnam terminated Harrison, and retained outside counsel to investigate the structured-credit group’s trading. Putnam then reported Harrison’s suspected misconduct to the SEC, along with the findings of its investigation.

Putnam also placed nearly $1.1 million in escrow to reimburse harmed clients, and it hired a compliance consultant to review and make recommendations on the firm’s policies and procedures related to cross trading and best execution. Putnam voluntarily implemented changes to its policies and procedures and implemented a training session in early 2017 for all fixed-income traders.

Putnam agreed to pay $1 million, and Harrison agreed to a nine-month suspension and $50,000 fine without admitting or denying the SEC’s charge.


The Putnam case was similar to the Hamlin Capital case in that improper crossing of illiquid securities was a central charge. The settlement order says Hamlin executed more than 15,000 cross trades between November 2011 and March 2016, and crossed the securities directly between customer accounts. The trading strategy employed by Putnam differed in that Putnam’s Harrison allegedly sold securities to brokers then repurchased them often a day later for a different account.

The SEC in the Hamlin case also cited significantly higher numbers of trades and client accounts, saying that in 2014 over 97 percent of Hamlin’s fixed income sales were made to other Hamlin clients. Hamlin also executed all of the cross trades with two broker-dealers because they were willing to execute the trades at “favorable, pre-determined, spreads that were narrower than the average bid/ask spread of trades in the same or similar securities executed in the secondary market during the relevant period.”

The pre-determined price at which the crosses were executed was determined by Hamlin and was commonly the bid side of the quoted market for the bonds. The practice benefited the buyers as they avoided paying the offer side of the spread of the secondary market quote. Buyers were, however, disadvantaged in some instances according to the SEC, as Hamlin arranged to effect crosses at prices determined by Hamlin. Hamlin challenged prices provided by the underwriter/broker to revise them up or down on occasion. These prices were also used to value client securities, according to the SEC.

Like Putnam, Hamlin’s practice was inconsistent with its disclosures in its Form ADV according to the SEC. From March 2012 through October 2014, Hamlin stated on the forms that it “maintain[ed] procedures which require that all cross transactions are made at an independent current market price.” However, despite the policy and written procedures, Hamlin consistently crossed bonds at the bid price throughout the period, according to the order.

Without admitting or denying the findings, Hamlin was censured and agreed to not to commit any future violations of Sections 206(2), 206(4){here} and 207{here} of the Advisers Act and Rules 206(4)-7{here} and 206(4)-8(a)(2){here}.

The SEC considered Hamlin’s cooperation and prompt remedial acts, as well its voluntary payment to affected clients of more than $675,000, in assessing a civil penalty of $900,000.

The primary benefit of crossing securities is often afforded to the seller in an illiquid security. For this reason, determination of price is a key factor. Regardless of whether the clients are a pooled vehicle such as a mutual fund, private fund, or individual retail accounts, all clients must be treated fairly. Whether a client is terminating a relationship and liquidating positions also cannot be a factor in determining price. The SEC says that in the Hamlin case sellers were disadvantaged by the practice of repeatedly executing bid-side only. However, there is an offsetting benefit for the sellers, in that the cross provided liquidity that otherwise would not exist.

This double-edged sword of liquidity benefit versus price is often a challenge that requires careful analysis, and rigorous documentation. Every cross executed will be scrutinized by regulators. Therefore, rigid policies and procedures, and documentation of such is essential. Determination of price must also be rigorously defensible and in accordance with stated policies and procedures.

There often is no clear-cut answer on this question of benefit, which is a good reason to consider not executing crosses. However, there are some instances where it may be beneficial to all parties, such as in index rebalances. If this is the case, proof of thorough analysis and documentation is essential.

Hamlin itself did not directly benefit from the crosses. However, if a firm has any economic interest in any of the involved accounts, the challenges and risk associated with crosses increase significantly as a conflict of interest is added to the equation.

If there is any economic interest for the manager — which is common in many hedge funds, or where performance-based fees are charged — the transaction is essentially viewed as a principal transaction where the manager becomes a participant to the trade.

Therefore, it is common for hedge funds to not effect crosses between funds.

When it comes to mutual funds, as with Putnam, cross trades are generally considered "affiliated transactions" prohibited under Section 17(a) of the Investment Company Act{here}. There are exceptions under Rule 17a-7; therefore, it is common that a fund's board of directors must vote on crosses, to protectively ensure that a cross meets all criteria, is in the best interest of all parties, and there are no conflicts.

The Hamlin and Putnam cases show the importance of compliance and legal oversight in determining whether to execute a cross transaction and ensuring that it is properly and fairly executed.

Client consent is also a necessity. Disclosure that a firm may engage in crosses is not adequate. Although many client management agreements may include language related to crosses, clear and detailed explanations and consent are a necessity.

When it comes to illiquid securities, extra caution is essential, as is clear documentation of the determining price factors. The avoidance of market impact to holders and the sellers must be weighed against any liquidity benefit.

Crossing policies often exclude trades with specific clients, such as pension plans and retirement accounts subject to the Employee Retirement Income Security Act (ERISA), or clients who have instructed the adviser not to engage in such trades. The Putnam case cites such client requests against crosses.

Compliance departments must ask trading desks or portfolio managers: Why is there a need for a cross? How does the cross benefit all of the funds or clients involved? Is one side of the trade benefiting more than the other side of the trade?

These are often difficult questions to answer. Therefore, often the safest course is to avoid the cross.

Perhaps the most important reminder for compliance departments is to make sure language is uniform in all policies, procedures, disclosures, customer or client consent forms, and regulatory forms such as Form ADV and the Form ADV brochure. Any conflicting language or vagueness will surely be spotted by regulators.

Crosses are a routine part of virtually every examination by regulators and the utmost care is essential. Crosses should not be overlooked and simply left to portfolio managers and traders, as regulators will demand supporting information. As can be seen in the Hamlin and Putnam cases, the ramifications of not getting them done right can result in costly regulatory actions.

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence based in New York. Email Todd at

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Oct 8. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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COLUMN-Loans could drain U.S. retirement plans by $2.5 tln
Gail MarksJarvis

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Gail MarksJarvis

CHICAGO, Oct 17 (Reuters) - Americans could dig a $2.5 trillion hole in the country’s retirement system as they fail to pay back loans taken from workplace retirement plans over the next 10 years, according to a new study from Deloitte Consulting.

The problem is called “leakage” - borrowing from a 401(k) plan without repaying the money or paying it back so slowly that it disrupts growth.

About 40 percent of people borrow from workplace plans. Most repay their loans within five years with interest, which is a typical requirement. But academic studies have found that about 10 percent default; often when laid off, which recalls the loan immediately. If you cannot repay the balance in cash, it counts as an early withdrawal, subject to taxes and penalties.

An additional problem is that two-thirds of people cope with that payback issue by pulling out the entire balance from their 401(k)s, according to Deloitte.

The result for a typical 42-year-old borrower, taking out a $7,000 loan from a $70,000 account: $300,000 less at retirement age than they would have had if they had never touched the money and investments gained 6 percent a year.


“People absolutely do not realize the consequences,” said Deloitte senior manager Gursharan Jhuty.

The financial industry has done little to plug the leaks. Instead, the focus of employers, fund companies and 401(k) administrators has been on getting people to save more. During the first half of this year about 55 million Americans had 401(K) accounts with a total of $5.3 trillion, according to the Investment Company Institute.

Loans are available in about 90 percent of plans because research indicates that people are more comfortable saving when they know they can withdraw money in a pinch.

People with incomes below $30,000 account for 22 percent of the borrowing, with 10 percent by people earning over $100,000, according to Vanguard. People borrow to deal with emergencies such as medical expenses or try to get rid of the pressures of other loans such as high-cost credit card debt. They also pull money to buy or renovate homes or for college tuition.

Here are some strategies experts think could help stop the drain:

Companies often require that employees have no more than one loan outstanding at a time, but Deloitte suggested they might also limit employees to an ongoing limit on loans.

Financial planners such as Charles Adi of Houston, Texas said he was comfortable with a single loan to pay off high credit card debt if the person does not add debt again and keeps saving. “I have them cut up their credit cards in my office,” he said.

It is also crucial before borrowing to examine whether a job is secure or whether there is another source of funds that could be used to pay back the loan if a layoff occurs.

Using a 401(k) loan for a home downpayment or maintenance can make sense provided jobs are secure, said White Plains New York financial planner Byrke Sestok. Yet, he and others discourage the use for college: “I tell them to have their child consider a less expensive school.”

Increasingly, companies are offering employees financial wellness programs to help with debt management and budgeting – practices that could keep them out of a financial bind in the first place if they use the advice.

In addition, Deloitte suggested employers require employees to get counseling before taking loans so they understand the impact of a lost job or the damage the loans could do to their retirement.

But counseling often comes too late, noted Kelley Long, a Financial Finesse financial planner who takes hotline calls from employees required to talk to advisers before pulling money from the 401(k).

At the point that people call in to a financial services company to discuss the loan terms, “it’s too late to fix the problem that led to the loan,” Long said. (Editing by Beth Pinsker and David Gregorio) / Marketing team /October 18 2018  //   14:45,

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