WAMCO Pays $100 Million: Failure to Supervise; Ken Leech, Former CIO, Guilty of Obstructing Investigation of His Fraudulent Scheme to Cherry Pick Trades

Western Asset Management Company’s (“WAMCO”) former Chief Investment Officer (“CIO”), Ken Leech, pled guilty to obstructing justice by giving false and misleading testimony to the SEC in connection with an investigation into Leech’s criminal scheme to favor certain clients at the expense of others.In a related matter, WAMCO agreed to pay a civil penalty of $100 million for failure to supervise Leech and for a failure to adopt the trade allocation policies and procedures described in WAMCO’s Form ADV.Leech, 72, is scheduled to be sentenced September 21st and, but for the plea deal, would face up to five years in prison; by entering into the plea deal, Leech avoided the more than 20 years he faced under fraud charges that were scheduled to go to trial June 15.

“Leech willfully and intentionally gave false and misleading testimony to the SEC in an effort to obstruct an investigation into his fraudulent scheme to favor certain clients at the expense of others,” said Deputy U.S. Attorney Sean S. Buckley. “Investment managers, like Leech, are entrusted by the SEC and the public at large to comply with their duty to be honest to regulators and fair to their clients. Today’s plea reflects the commitment of this Office and its law enforcement partners to protecting everyday investors—in New York City and abroad—from investment advisers who violate their legal commitments and seek to deceive clients for their gain or the gain of others.”

As alleged, between January 2021 and October 2023 (the “Relevant Period”), Leech committed fraud and abused the trust placed in him by clients of the investment-management firm WAMCO. Leech engaged in a criminal scheme commonly known as cherry-picking to compensate for losses in his marquee investment strategy [Macro Opps] by assigning trades that performed well during their first day into client accounts associated with that investment strategy, and assigning trades that performed poorly over their first day into the accounts of other clients, who were not aware that Leech was causing them losses to favor others. Leech’s victims included institutional and retail investors who entrusted Leech to manage their savings and pension plans. Over the course of his criminal scheme, Leech allocated trades with net first-day gains of at least $600 million to his favored strategy and clients, and allocated trades with net first-day losses of at least $600 million to strategies and clients to whom he owed an equal fiduciary duty.

In an effort to obstruct the investigation of that fraudulent scheme, Leech testified before the SEC that he knew where he planned to allocate trades at the time he placed them. The facts proved otherwise. Leech owed a fiduciary duty to all of his clients. But Leech improperly engaged in a scheme to delay his trade allocation instructions to allocate trades across clients in a manner that benefited some clients and harmed others.

According to the SEC complaint, Leech managed clients in three fixed income strategies: (1) Western Asset Macro Opportunities strategy “Macro Opps”; (2) Western Asset US Core Strategy (“Core”); and (3) Western Asset US Core Plus strategy (“Core Plus”).In many respects the three strategies were similar, and each held cash securities and related derivatives, including Treasuries and Treasury derivatives, investment grade corporate bonds, high yield bonds, and mortgage-backed securities.An investment opportunity suitable for Macro Opps was frequently suitable for Core or Core Plus.

Management fees paid by clients in the Core and Core Plus strategy ranged from 5 to 45 basis points with a majority paying 30 basis points or less.For Macro Opps clients the management fee ranged from 40 to 115 basis points with most paying 60 basis points or more.Also, only clients in the Macro Opps strategy paid a performance fee—not Core or Core Plus clients.As a result of this fee structure, each dollar of AUM in Macro Opps could generate four times as much revenue for WAMCO as each dollar in Core and Core Plus.Leech was incentivized to maximize the performance of Macro Opps clients to generate more revenue for WAMCO and increase Leech’s own bonus compensation, which was tied to the firm’s profits.And this is exactly what he did.Understanding financial incentives (and the conflicts they create) and paying careful attention to how those incentives might modify trade allocations is an important compliance mindset.

Leech typically placed his early morning trades by telephone (and not through the electronic order management system described below) in an omnibus account (aggregate, non-client specific, account) at each broker with whom he traded.Leech’s trade assistant would unsuccessfully attempt to get Leech’s client allocation instructions for each trade.The trade assistant would not hear back from Leech for the majority of his trades until after 4 pm, until Leech could observe how the trades had performed during the day.Armed with that performance knowledge, Leech would allocate favorable trades to favored clients and losers to the disfavored group.

During WAMCO’s compliance training, the CCO warned employees to finalize allocations and the trade ticket promptly after trade execution.This training was supplemented by email reminders from the CCO.Also, WAMCO’s electronic order management system allowed portfolio managers to prepare draft trade tickets and specify allocation instructions per client prior to placing a trade; most of WAMCO’s portfolio managers used this system and pre-allocated trades before placing the order.Leech, obviously did not follow this approach.

WAMCO’s Form ADV Part 2A Brochure, which was provided to clients, provided that investment allocations are done in a manner that is fair and equitable, with the presumption that similarly situated clients should generally participate in similar investment opportunities and trades and that it maintained a variety of policies and practices designed to reduce the potential for favoritism.

The policies and procedures and training were probably adequate; their implementation, however, was not. The compliance breakdown was an unwillingness (for far too long) for senior management, oversight committees and the CCO to challenge the noncompliant allocation practices of a senior, portfolio manager who also happened to be the CIO of a $300 billion plus investment manager.There is no excuse to permit any portfolio manager, no matter how intimidating, to consistently wait until the end of the trading day to allocate trades to specific clients, particularly at a firm that went to the trouble of designing and implementing an order management system that permits and encourages pre-trade allocations.Disparate unexplained performance for clients and portfolios that have substantially similar investment objectives and portfolio composition should also raise alarm bells that result in immediate scrutiny: WAMCO purportedly paid strict attention to portfolio performance on a daily basis.

Also, investment opportunities that are suitable for multiple clients should, as a general rule, be allocated on a standard, formulaic basis (such as pro rata) with additional scrutiny on those trades that are allocated in a manner other than the standard approach.Each trade that is allocated in a nonstandard manner should be accompanied by a succinct written explanation from the portfolio manager that is periodically reviewed with professional skepticism (and considering the financial incentives such as those described above) for the explanation given.The SEC’s Fiduciary Interpretation states that an adviser need not have pro-rate allocation policies, or any particular method of allocation, but, as with other conflicts and material facts, the adviser’s allocation practices must not prevent it from providing advice that is in the best interest of its clients.