SEC Sanctions Affiliated Advisers for Errors & Violations

Ethan CoreyLegal Insights

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On July 2, 2020, the Securities and Exchange Commission (SEC) announced settled charges against California-based Franklin Advisers, Inc. (Franklin Advisers), a registered investment adviser, for breaching its fiduciary duty to its client funds and failing to follow its own policies and procedures, and settled charges against Franklin Advisers and Toronto-based Franklin Templeton Investments Corp. (Franklin Templeton Canada), also a registered investment adviser, for causing client funds to violate investment limitations.

According to the SEC’s order, from October 2013 to November 2015, both Franklin Advisers and Franklin Templeton Canada purchased certain exchange-traded funds on behalf of client funds, causing the funds to exceed the limits set forth in Section 12(d)(1)(A) of the Investment Company Act of 1940 (1940 Act), which prohibits investing more than 10% of an investment company’s assets in other investment companies or acquiring in excess of 3% of the outstanding shares of an investment company.

Franklin Advisers

From December 2014 to November 2015, several registered investment companies advised by Franklin Advisers (Franklin Funds), including certain asset allocation funds (Allocation Funds) purchased shares of three exchange-traded funds (ETF No. 1, ETF No. 2, and ETF No. 3), all registered, unaffiliated investment companies. At the time of those purchases, each fund’s holdings of investment companies in the aggregate exceeded 10% of its assets, which is generally prohibited by Section 12(d)(1)(A) of the 1940 Act.  Franklin Advisers attempted to rely on Section 12(d)(1)(F) to permit each of the Franklin Funds to hold shares of investment companies in excess of the 10% prohibition, i.e., each of the Franklin Fund’s holdings of other investment companies, including the shares of ETF Nos. 1 through 3 and all other registered investment companies, could have an aggregate value of more than 10% of the fund’s total assets. However, Franklin Advisers’ aggregate purchases of ETF Nos. 1, 2, and 3 caused the Franklin Funds to exceed the firm-wide 3% ownership limits of Section 12(d)(1)(F) for each ETF.

error message backgroundFranklin Advisers was responsible for implementing the Franklin Funds’ written policies and procedures.  Franklin Funds’ written policies and procedures included policies and procedures designed to comply with Section 12(d)(1)(A).  The written policies and procedures called for pre-trade screening of any trades that would rely upon the Section 12(d)(1)(F) exemption.  However, Franklin Advisers, failed to implement a pre-trade screening process with regard to Section 12(d)(1)(F) called for in the written policies and procedures.  Consequently, certain of the Franklin Funds’ purchases of ETF Nos. 1 through 3 exceeded the 3% complex-wide ownership limit with respect to holdings in the three ETFs.

On November 24, 2015, Franklin Advisers’ compliance department discovered the breaches of the limits in Section 12(d)(1)(A).  Because of those breaches, on November 25, November 27 and November 30, 2015, Franklin Advisers reduced the Franklin Funds’ positions in the ETFs to bring complex-wide ownership within the 3% limit of Section 12(d)(1)(F).  As a result, the Allocation Funds realized losses of $2,184,031 for ETF No. 1 and gains of $3,723,124 and $4,747,560 from selling their holdings in ETF Nos. 2 and 3, respectively.

Franklin Advisers’ trade error policy, which had previously been provided to the Franklin Funds’ board, normally required that Franklin Advisers reimburse losses incurred by clients for a security bought or sold in contravention of regulatory investment restrictions.  However, Franklin Advisers ultimately determined, as a result of offsetting gains that the Allocation Funds earned from selling two different securities—shares in ETF Nos. 2 and 3— that it would not reimburse those funds’ losses in ETF No. 1.

Franklin Advisers’ decision not to reimburse the Allocation Funds was made while it had a conflict of interest created as a result of its financial incentive to avoid having to reimburse the Allocation Funds for the losses resulting from the corrective sales of ETF No. 1.  Franklin Advisers failed to disclose this conflict of interest to the board of those funds. 

Moreover, the manner in which Franklin Advisers determined that it would not reimburse those funds for the losses violated Franklin Advisers’ own policies and procedures.  Under normal circumstances, Franklin Advisers’ trade error policy required Franklin Advisers to reimburse for client losses on trade errors.  The trade error policy provided for an alternative method of correcting a trade error, but only under certain circumstances and with the approvals of designated Franklin Advisers officers.  However, Franklin Advisers did not conduct an analysis under any alternative method and compliance never obtained the requisite approvals. Furthermore, Franklin Advisers’ policies and procedures required Franklin Advisers to document all trade errors, circulate the documentation to senior officers in the affected departments, and report the errors and corrective action to the board of trustees.  Franklin Advisers failed to follow these policies or procedures.

Instead, Franklin Advisers first reported the Section 12(d)(1)(A) violations by the Allocation Funds to the Allocation Funds’ board in a June 2016 memorandum.  In July 2016, Franklin Advisers discussed the violations at a board meeting.  In neither of these instances did Franklin Advisers identify the Allocation Funds’ realized losses as the result of the corrective sales of ETF No. 1, advise the board that Franklin Advisers would not be reimbursing the Allocation Funds for the losses, disclose its conflict of interests in determining not to reimburse the Allocation Funds for their losses, or advise the board that Franklin Advisers had not followed its policies and procedures in making its determinations.

Franklin Advisers first disclosed to the Allocation Funds’ board the losses that the Allocation Funds incurred on the corrective sales of ETF No. 1 in February 2018, only after the SEC began its investigation.  In December 2018, Franklin Advisers fully reimbursed the Allocation Funds for these losses, including interest.

Franklin Templeton Canada

From approximately February 2015 to September 2016, six Canadian investment companies managed by Franklin Templeton Canada and not registered under the 1940 Act (Quotential Funds), acquired shares of ETF No. 4, an unaffiliated, registered investment company, in excess of the 3% limit in Section 12(d)(1)(A)(i).  Each of the six Quotential Funds purchased the shares in amounts ranging from 3.309% to 24.635% of the outstanding shares of ETF No. 4.  In the aggregate, the Quotential Funds acquired between 64.59% to 90.65% of ETF No. 4 during that time.

In approximately October 2015, when the six Quotential Funds had acquired approximately 78% of the outstanding shares of ETF No. 4, the Quotential Funds’ portfolio managers proposed to the investment adviser of ETF No. 4 that Franklin Templeton Canada would increase the Quotential Funds’ investments in the ETF in exchange for a reduction in the management fee and absent such a fee waiver, would redeem their entire existing investment.  The ETF’s adviser agreed and, after informing the board of ETF No. 4, reduced the management fee by 15 basis points for all shareholders.  The Quotential Funds proceeded to purchase an additional 12% of the ETF’s shares.  The Quotential Funds’ ownership levels of ETF No. 4 peaked in February 2016 when their holdings totaled 90.65% of the ETF’s shares.

In addition, from approximately October 2013 to September 2016, five Quotential Funds acquired shares of ETF No. 5, a registered, unaffiliated investment company, in excess of the 3% limit in Section 12(d)(1)(A)(i).  Each of the five Quotential Funds acquired the shares in amounts ranging from 3.038% to 20.72% of the then outstanding shares of ETF No. 5.  In the aggregate, the five Quotential Funds’ acquisitions totaled between 24% to 29% of ETF No. 5 during that period.

The SEC order took the position that as investment companies, the Quotential Funds’ purchases of the shares of ETF Nos. 4 and 5—both registered investment companies—were subject to the 3% limit in Section 12(d)(1)(A)(i).  While the issuers of ETF Nos. 4 and 5 had obtained exemptive relief from Section 12(d)(1)(A) from the SEC on behalf of “certain registered open-end management investment companies” to acquire each ETF’s shares, the Quotential Funds could not rely upon this relief because they were unregistered investment companies.

Sanctions Assessed

Franklin Advisers

The SEC found that Franklin Advisers caused certain Franklin Funds to violate:

  • Section 12(d)(1)(A)(iii) of the 1940 Act (the prohibition against funds acquiring other registered funds if, after the acquisition, registered funds account for more than 10% of the total assets of the acquiring funds); and
  • Rule 38a-1(a) under the 1940 Act (the requirement that registered investment companies adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws by the fund, including policies and procedures that provide for the oversight of compliance by the fund’s investment adviser).

The SEC also found that Franklin Advisers willfully violated Sections 206(2) and 206(4) of the Advisers Act, and Rule 206(4)-7 under the Advisers Act (the investment adviser compliance rule). 

The SEC took no action against the funds themselves, nor against any of the personnel involved.

Takeaways

Our takeaways from this aspect of the enforcement action are:

  • Advisers should tick and tie their policies and procedures to their actual processes.  Every policy should have underlying procedures and processes that are reasonably designed to achieve compliance with such policy.
  • Trade error policies and remediation efforts thereunder continue to be an area that the SEC staff will focus upon when they are reviewing for conflicts management.  Exceptions that are not resolved in favor of the clients should be carefully reviewed with an Adviser’s legal and compliance counsel, and full disclosure made to the board or governing body of any fund or other client affected thereby.
  • Trade error policies are often written in a way that puts investment advisers in the position of being an absolute insurer of a very particular and specific process.  Some may view such policies as a reflection of “best practice.”  However, a trade error policy that is crafted to equate each and every deviation from a client mandate, regardless of materiality, to an “error” requiring remediation could be unnecessarily burdensome when other adequate and equitable remedial actions would suffice.  Advisers should review their policies and procured to ensure they are specifically crafted to accomplish their objective. 

Franklin Templeton Canada

The SEC found that Franklin Templeton Canada caused the Quotential Funds to violate Section 12(d)(1)(A)(i) of the Investment Company Act, which prohibits investment companies – including unregistered investment companies – from acquiring more than 3% of the outstanding voting stock of a registered investment company. The SEC fined Franklin Templeton Canada $75,000 and ordered it to cease and desist from committing or causing any violations and any future violations of Section 12(d)(1)(A).  However, the SEC order does not assert that Franklin Templeton Canada itself violated any federal securities law.   

The action brought against FTIC raises a subsidiary question – to wit, would the SEC fine Franklin Templeton Canada, a registered investment adviser, but not find that it violated any particular federal securities law?  We believe that there are a couple of possible explanations.  First, the SEC takes the position that it will not seek to apply the Advisers Act to a non-U.S. adviser that is registered with the SEC with respect to its non-U.S. clients.  Franklin Templeton Canada is a non-U.S. adviser and the Quotential Funds are non-U.S. clients.  Moreover, while Section 12(d)(1)(A) applies to purchases of registered investment company securities by unregistered investment companies, it is unclear whether the jurisdictional reach of Section 12(d)(1)(A) encompasses foreign investment companies.  While the SEC staff has taken the position that it does, Section 12(d)(1)(B), which prohibits registered open-end funds from selling their shares to registered and unregistered investment companies in excess of the limits set forth in that statute, was enacted to prevent foreign investment companies from becoming fund of funds – presumably because of concerns about jurisdictional reach. 

The SEC may have determined that as long as it could get Franklin Templeton Canada to admit that it caused a violation of 12(d)(1)(A), it did not need to cite it for a specific securities law violation of its own. 

Conclusion

Every few years, there is another SEC enforcement action that reminds investment advisers to review their trade error policies to ensure that they are being implemented as written.  A principle that is simple on its surface – namely, that an investment adviser has a fiduciary duty to make a client whole in the event of a trading error – can end up raising a host of thorny issues.  What types of acts or omissions constitute errors?  If an error affects multiple clients, can you treat different clients differently?  Can a trade be an error with respect to one client but not with respect to another client?  Can gains be netted against losses?  Can a client ever vary from its trade error policies?  What does it mean to make a client whole?  How much involvement by the client in the outcome is prudent?  Or necessary?

Given the legal, financial and reputational risks involved with trade errors and their correction, investment advisers may find it prudent to obtain counsel’s review of their trade error policies.