Recent SEC Enforcement Actions Focus on Operational Compliance, Conflicts of Interest, and the Custody Rule

Three recent SEC enforcement actions illustrate the current Commission’s continuing focus on operational compliance, conflicts of interest, and the Custody Rule. Read summaries of each administrative proceeding below.

Western Asset Management: Trade Allocation Controls

On June 5, the SEC announced settled charges against Western Asset Management for failing to detect and prevent a former co-Chief Investment Officer’s alleged cherry-picking scheme (link). The SEC previously charged Stephen Leech with allocating trades with first-day gains to favored portfolios and trades with first-day losses to disfavored portfolios between 2021 and 2023.

According to the SEC, Western Asset knew or should have known that Leech’s trading and allocation practices differed from other portfolio managers. He often placed trades by phone, did not document intended allocations at or near the time of trade, and entered allocations near or after daily settlement prices were set. The SEC found that this created an opportunity to allocate trades based on intervening market performance, contrary to the firm’s fiduciary obligations and disclosures that allocations would be fair and equitable.

Without admitting or denying the findings, Western Asset agreed to a cease-and-desist order, a censure, and a $100 million civil penalty, which the SEC intends to distribute to harmed investors through a Fair Fund.

Compliance Considerations: Review allocation timing, supervisory oversight, exception reporting, and post-trade testing to confirm that allocation practices remain fair, equitable, and consistent with client disclosures.

Foundations Investment Advisors: Conflicts of Interest and Code of Ethics

On June 8, the SEC announced settled charges against Foundations Investment Advisors, LLC and its former Chief Executive Officer, Bryon E. Rice, for breaches of fiduciary duty and other violations (link). According to the SEC, Foundations failed to disclose conflicts of interest related to investments it recommended to advisory clients, including Rice’s profit-sharing interest in a Foundations sub-adviser, an expense sharing agreement that gave Foundations an incentive to recommend certain ETFs, and affiliations involving the firm’s former Chief Investment Officer.

The SEC also found that Rice personally traded an ETF while serving as CEO and while aware that the ETF was included in a sub-adviser’s model portfolio recommended to Foundations clients. Rice allegedly failed to pre-clear the trading as required by firm policy. The SEC found that Foundations failed to implement compliance policies relating to conflict disclosures and annual reviews, and failed to enforce its Code of Ethics pre-clearance requirements.

Without admitting the SEC’s findings, Foundations agreed to a cease-and-desist order, a censure, disgorgement of $152,628, prejudgment interest of $15,031.17, and a $1.2 million civil penalty. Rice separately agreed to a cease-and-desist order, a censure, disgorgement of $434,162, prejudgment interest of $5,395.28, and a $354,675 civil penalty.

Compliance Considerations: This matter reinforces the need to identify economic interests, affiliate relationships, and product-related incentives before recommendations are made to clients. It also shows why Code of Ethics controls should be tested in practice, especially for senior personnel and investment committee members.

Northeast Financial Group: Custody Rule Audits

On June 26, the SEC announced settled charges against Northeast Financial Group for failing to comply with the Custody Rule’s annual audit requirements for four private funds over multiple years (link). According to the SEC, the firm failed to obtain the required annual audits and distribute audited financial statements to investors as required by Rule 206(4)-2 under the Advisers Act.

Without admitting or denying the SEC’s findings, Northeast Financial Group agreed to a cease-and-desist order, a censure, and to pay a $150,000 civil penalty.

Following the settlement, former Chief Compliance Officer Robert Hackenberg stated publicly that the firm had relied on incorrect outside legal advice regarding the audit requirements. Although Hackenberg was not named in the SEC’s enforcement action, the matter serves as a reminder that advisers remain responsible for understanding and complying with applicable regulatory requirements.

Compliance Considerations: Periodically evaluate whether the Custody Rule applies to the firm’s activities and confirm that audit requirements are satisfied for all pooled investment vehicles.

Takeaways

• Compliance policies must be implemented, not simply adopted.
• Conflicts of interest should be identified proactively and disclosed completely.
• Supervisory reviews should validate that day-to-day practices are consistent with written policies.
• Periodic compliance testing remains one of the most effective ways to identify operational weaknesses before regulators do.