Trade allocations by portfolio managers are coming under increased scrutiny as federal prosecutors charge a high-profile bond fund manager at Western Asset Management Company with a $600 million “cherry-picking” scheme. This incident has triggered industry-wide introspection, with investment firms reassessing trading policies and practices to ensure compliance with regulatory standards.
On November 25, the U.S. Attorney’s Office for the Southern District of New York unsealed an indictment against Ken Leech, former co-chief investment officer at Western, a division of Franklin Resources. Leech faces four counts of fraud and one count of making false statements.
The Securities and Exchange Commission (SEC) also filed civil charges, alleging that Leech engaged in a multiyear scheme to allocate favorable trades to select portfolios while assigning less favorable trades to others. This practice, known as “cherry-picking,” violates fiduciary duties owed to clients.
“Investment advisors must always act in their clients’ best interests, particularly when it comes to trade allocations,” stated Sanjay Wadhwa, Acting Director of the SEC’s Division of Enforcement.
Industry Responds to Allegations
Western Asset Management responded swiftly, with spokeswoman Jeaneen Terrio confirming that the firm has cooperated with investigations. She added that Western has enhanced its trading policies following an external review.
Meanwhile, industry analysts anticipate broader scrutiny of trade allocation practices. “I wouldn’t be surprised to see increased regulatory focus on trade allocations,” said Morningstar analyst Max Curtin. “This case highlights the centrality of fairness in trading practices.”
The case at Western has spotlighted challenges within trade order management systems, particularly for non-equity trades like fixed income and derivatives.
“Trade order systems are better suited for equities,” explained Salvatore Faia, CEO of Vigilant Compliance. “They can efficiently allocate shares across accounts based on stock prices. However, for fixed income or derivatives, the process is often more manual, creating opportunities for deviation from stated policies.”
The Complexity of Trade Rotation
Trade rotation, designed to ensure fairness in allocations, presents its own challenges. Portfolio managers serving both institutional and wealth management clients often use rotation systems, but these can inadvertently create winners and losers.
“Fixed income transactions, for example, are rarely subject to trade rotation due to settlement differences and platform constraints,” said David Choate, COO of Capis, a compliance-focused trading services firm. “The industry needs to address these gaps to enhance fairness.”
The SEC has increased its focus on trade allocation practices, with recent examinations targeting whether certain clients are favored without proper justification.
“This year, we’ve seen a noticeable uptick in advisor examinations related to trade allocations,” Faia noted. “Regulators are emphasizing fiduciary duty, and trade allocations are a key part of that.”
Proactive Compliance
The SEC’s priorities for fiscal year 2025, outlined in October, emphasize adherence to fiduciary standards. Since news of the Western case surfaced, many investment firms have proactively reviewed their trade allocation policies.
“Advisors are asking us to assess their processes to ensure compliance,” Faia said. “They want to be ahead of potential regulatory scrutiny.”
In its November 25 complaint, the SEC alleged that Leech violated Western Asset’s trade allocation policies by bypassing its electronic trading systems and failing to document intended allocations. Instead, he placed trades directly with brokers, a deviation from standard practices.
Leech’s attorney denied the allegations, stating that the portfolio manager “received no benefit from the alleged misconduct.”
Regulatory Outlook
As the industry grapples with these issues, the political landscape could introduce new variables. President-elect Donald Trump’s administration has signaled plans to reduce regulation in the financial sector. However, experts believe the SEC’s focus on protecting investors through trade allocation oversight will persist.
“While the new administration may push for deregulation broadly, I don’t expect significant changes in how the SEC approaches trade allocation issues,” Faia said. “Protecting the public will remain a priority.”
Implications for Wealth Advisors and RIAs
The fallout from the Western Asset case has implications for wealth advisors and registered investment advisors (RIAs). Trade allocation practices are a cornerstone of fiduciary duty, and advisors must ensure that their processes can withstand regulatory scrutiny.
Advisors should consider conducting regular reviews of their trade allocation policies, particularly for non-equity trades. Given the limitations of trade order systems for fixed income and derivatives, firms may need to adopt additional safeguards or manual checks to ensure fairness.
Client communication is also critical. Advisors must clearly articulate their trade allocation methodologies to clients, emphasizing transparency and fairness. This is particularly important for clients with diverse portfolios spanning equities, fixed income, and alternative investments.
The case also underscores the importance of leveraging technology effectively. While trade order systems have limitations, advancements in automation and analytics can help mitigate risks and enhance compliance. Advisors should explore tools that can streamline trade allocation processes while ensuring adherence to fiduciary standards.
Lastly, advisors should stay informed about regulatory trends and be prepared for potential changes in examination priorities. Proactive compliance measures, such as third-party reviews, can help advisors demonstrate their commitment to best practices and client interests.
A Call to Action
The Western Asset case serves as a reminder of the critical role advisors play in safeguarding client interests. As the industry faces heightened scrutiny, wealth advisors and RIAs must prioritize robust trade allocation practices, transparency, and adherence to fiduciary duties.
By staying proactive and vigilant, advisors can navigate these challenges effectively, preserving trust and delivering value to their clients in an increasingly complex regulatory environment.
