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News May 23, 2005 Issue

A Practical Guide to Error Correction (Part 1 of 2)

"Great services are not canceled by one act or by one single error."

- Benjamin Disraeli

Trading errors are inevitable. The trick, of course, is to appropriately handle errors as they come to your attention, quickly catch the ones that donít jump out at you, and minimize the likelihood of errors in the first place.

There is little SEC guidance on error correction. In a 1988 no-action letter, the SEC staff stated that an adviser is obligated to place orders correctly for its clientsí accounts, and if it makes an error while doing so, it must bear any costs of correcting the trade.

Historically, there have been only a handful of enforcement cases relating to error correction. However, within the past year, the SEC has brought three error correction-related cases against advisers: Van Wagoner, EGM Capital/Michael Jackson, and William Belko.

In practice, most firms adopt the golden rule that their clients will not incur any losses resulting from the adviserís errors. In addition, many firms take the position that clients are entitled to any gains resulting from the adviserís errors. However, some advisers, particularly those in the hedge fund world, take the position that with proper disclosure, the adviser may keep any gains arising from errors, or use them to offset losses caused by errors in the same clientís account. Some hedge fund advisers go farther and disclose that the fund may be expected to eat the adviserís trading errors, since errors, they say, are a normal by-product of the adviserís rapid-fire trading strategy. By and large, however, most investment management lawyers would strongly caution against asking clients to view errors as a cost of doing business.

Regardless of whether you take an aggressive or conservative approach to error correction, thereís one rule that all advisers should follow: when an error comes to your attention, take steps to proactively deal with it. Although painful, the fact that an error has occurred is not going to be deadly to your firm. However, as the SEC enforcement cases demonstrate, firms and individuals can quickly get themselves into a heap of trouble by ignoring an error or, worse, attempting to cover it up.

Whatís a trade error? Trade errors are a separate species distinct from other types of mistakes that advisers might make, such as errors in calculating performance figures or NAVs. The classic examples of trade errors involve slipped keystrokes, messy handwriting, or other human miscommunications, where:

  • IBM becomes IBN;
  • ".5" percent becomes "5" percent;
  • 10,000 shares becomes 100,000 shares;
  • a buy becomes a sale; or
  • Account 478 becomes Account 479.

Other errors are less obvious, such as when a transaction violates a specific account restriction. Keep in mind that an account restriction can arise from a variety of sources: the federal securities laws, state pension statutes, prospectus disclosure, or the clientís own investment guidelines. For example, if affiliated stock is purchased by a mutual fund or ERISA account, in violation of applicable affiliated transaction restrictions, youíve got a trade error (as well as potential violation of the law, so call your favorite lawyer pronto).

Other less obvious trade errors:

  • a limit order trade is executed at market price;
  • a portfolio managerís order fails to be executed;
  • a clientís instruction fails to be followed;
  • an order to buy a position is placed, but the clientís account does not have sufficient funds to cover the purchase;
  • bunched trades are allocated incorrectly (but see the SMC Capital letter, which notes that accounts that are belatedly determined not to be eligible for a security may be backed out of an allocation after the bunched trade is executed, provided that the reallocation is fair and the firmís compliance officer signs off, in writing, on a written explanation for the reallocation, no later than one hour after the markets open the next trading day).

Also keep in mind that some types of trade errors may involve a trade made without necessary authorization. For example, a trade made for a non-discretionary account without obtaining client approval is an error, as is a principal trade made without obtaining the clientís consent. Unlike other types of errors, these types of errors may not involve economic loss to the client.

Whatís not an error? Some examples:

  • an incorrect trade that is caught and broken before settlement without any negative economic impact to the adviser or its client;
  • a trade that was properly executed, but improperly documented (caution: SEC examiners will likely probe whether the improper documentation was "discovered" with 20/20 hindsight to cover up an erroneous trade); or
  • brokerís errors, custodianís errors, or errors of other unaffiliated third parties (of course, as the clientís fiduciary, the adviser still may need to be diligently involved in overseeing the resolution of a third-partyís error).

Hereís Morgan, Lewis & Bockius partner Steve Stoneís advice on the whole "whatís a trade error" question: "Donít get caught up in the semantics." The term "trade error," he explained, is not defined by the law. Whether itís a classic trade error (a finger slips and an extra zero is added) or something more exotic (a limit order is accidentally executed at market price), advisers should recognize the general principal that when placing trades, they owe clients a duty of care. The important thing isnít whether something is a "trade error," he explained, itís whether or not the adviser has breached that duty.

Should advisers have a written error correction policy? The SEC doesnít require it per se, but it does seem like a good idea. "Itís not a flat-out requirement, but the SECís examination staff can tie it back into the compliance program rule," said Jeff Morton of Adviser Compliance Associates (which owns IM Insight). Moreover, he added, a "strong argument" can be made that having written error correction policies and procedures is "in accordance with industry best practices."

In 1992, the SEC brought a failure to supervise charge against M & I Investment Management Corporation, after the firmís president attempted to fix an error by moving shares between clients accounts. The SEC noted that the handling of the error was totally within the presidentís discretion. The firm "had no procedure in place to direct that trading errors be handled in a particular, and proper, manner, or that disclosure of the nature and extent of the error and of the proposed method of rectifying it be made to any particular person or entity," said the SEC.

And that, of course, was well before the compliance program rule. "In this environment," said Stone, "I donít think thereís any question that firms better have a policy and procedure on trade errors. You ought to have them."

What should an error correction policy cover? Perhaps more so than any other firm policy or procedure, a firmís trading error correction procedures should provide maximum flexibility to handle a variety of situations, given the unique facts and circumstances surrounding each trade error. While the procedures should establish some general principles, they should not codify unnecessary details that may rub up against reality. For example, think twice before drafting procedures that require errors to be handled within a specified time. Youíll want to provide flexibility to allow for delays necessitated by ascertaining facts, notifying and involving clients, and potentially involving the firmís E&O insurance carrier. There may be other delays, as well: an erroneous position in illiquid securities may have to be carefully sold over a period of time.

When drafting policies and procedures, some items to consider:

  • When an error is discovered, who within the firm will be alerted? Is there an "error point person" within the firm? Will the compliance department be notified? Will the resolution of the error be handled by the firmís trading desk, the compliance department, or client services?
  • Is there some level of magnitude at which errors will be brought to the attention of the firmís senior management, outside counsel, and/or board?
  • Will clients be notified that an error has occurred within their account? For any and all errors? For errors above a de minimis level? Only when the client has suffered harm and is going to be reimbursed? Will notice be provided orally or in writing? Will clients be notified prior to resolution of the error so they can be involved in the solution?
  • How will the error be corrected? Will erroneous positions be sold back into the market? Will the firm use an error account?
  • Who will determine whether the firmís E&O carrier needs to be notified and involved in the resolution of the error? Who will make that notification?
  • Will employees be sanctioned? If so, make sure employees are sanctioned only for failing to follow the error correction procedures, rather than for making the error in the first place (so as not to chill reporting of future errors).
  • What routine checks will be made to ferret out undiscovered errors?

Should we keep a trade error log? Itís not a bad idea. Recent OCIE exams have asked advisers to provide a list of trading errors during the inspection period. Having a log handy can facilitate a response to this question. In addition, a log can serve as a tool to identify patterns of errors that indicate an internal control weakness. It also can be utilized as part of the firmís annual compliance program review.

Each entry in the error log might list:

  • a plain English description of the error;
  • a plain English description of how the error was resolved;
  • information about the security involved (name, amount, date, time, and price(s) at which the erroneous order(s) was initially executed, and date, time, and price(s) at which it was corrected;
  • the account(s) affected by the error;
  • who within the firm was responsible for the error; and
  • supporting documentation, including order tickets, client correspondence, and internal e-mails relating to identification and resolution of the error.

How should trade errors be handled? Typically, trade errors will first come to the attention of the firmís portfolio managers or traders. Keep in mind that their instinct might be to treat the erroneous position like a hot potato (i.e., get rid of it as soon as possible). That instinct might not be the best one.

Stone suggested that the firmís error correction procedures require any firm employee who becomes aware of a potential error to notify the firmís CCO (or another individual in the firmís legal and compliance department). The CCO should then quickly work to ascertain the pertinent facts. Only then, and with the involvement of any client relationship person, should the client be contacted. The client should be told what happened and why it happened, based on a full understanding of the facts, Stone said. The trader or portfolio manager should not simply pick up the phone and call the client, he added. Even in smaller firms, to the extent possible, the person who caused the error should not be the person responsible for resolving it.

However, this fact-gathering should all be done with urgency. And, cautioned Stone, "you need to achieve some balance." It may take some time to put the picture together, and in the interim you donít want to be sitting on an erroneous position. For example, if your firm erroneously purchased a sin stock and the stock is falling, the firm should sell it into the market immediately and discuss things with the client later.

In addition, to the extent that you anticipate that the error will result in a claim on your E&O policy, firms should involve their insurance carrier in the error resolution process. Stone noted that advisers typically do not make claims on small errors. However, for big errors, "youíd better bring them up to speed as soon as you understand the facts." A good place to start, he said, is by reviewing your E&O policy. He cautioned that some advisers might be surprised to see that their policy does not, in fact, cover trading errors. He also cautioned that a "confession" to a client about an error may "complicate" the ability of the firm to receive coverage for the error, as some E&O policies state that the firm may exclude coverage where an adviser has admitted negligence.

How do we calculate losses? As noted above, industry best practice is that clients should not bear any loss as a result of an advisory firmís errors. That, said Morton, is "pretty standard." Whatís not standard, however, is how to go about calculating that loss. For example, losses can include:

  • the decline in value of the erroneous position while held in the clientís account;
  • any commissions, ticket charges, and other transaction expenses incurred in making the erroneous trades; and
  • the opportunity cost (i.e., had the money been invested properly or differently, what gains would the client have enjoyed?).

Calculating the loss in the erroneous position is straightforward, assuming market prices are readily available. Similarly, calculating transaction charges is a snap ó just look at the confirms. However, to calculate the opportunity costs of being in the erroneous position, youíll have to be a bit of an economist. If it is clear that the client should have been in a particular stock at a particular time (i.e., in IBM, not IBN), the opportunity cost is straightforward: itís the gain (if any) that the client would have realized from being in IBM in the first place.

But what if the firm discovers that a properly executed sin stock violates a clientís investment mandate? To calculate the opportunity cost, the firm would have to determine what it would have done with the cash used to buy the sin stock, had it not done so. Thatís a bit subjective, of course, and as a result many firms simply pay interest, based on the prevailing T-bill or money market rate, on the cash. Other advisers would look to the performance of a relevant benchmark, or the performance of the account itself, based on the assumption that the cash would have been invested in the market.

However, as Stone pointed out, things can get even more complex. Letís say the sin stock went down in value, but not as much as the overall decline in the account. Was there a loss? Were it not for the clientís position in the sin stock, for example, the client might have incurred a greater loss. Also, consider whether there was a specific position that was sold to free up cash for the erroneous purchase. "That thing that you dumped also may have tanked," Stone said, perhaps even more so than the erroneous position.

The upshot: "Itís important for an adviser to understand that there are multiple possible ways to calculate a loss," said Stone. The adviser should present the "continuum of options" and "let the client choose" the option it feels is fairest. The presentation of options, however, should be presented as objectively as possible. "In your discussions with the client about what happened and why it happened and what it cost them, you need to be candid and give them a fair and balanced presentation," he said. Stone noted that when discussing errors, there can be a "human temptation to shade the full story." Since trade error correction "will be subject to the greatest scrutiny" from the SEC, firms should make an extra effort to be completely straight-forward.

Next week: erroneous gains, netting, error accounts, preventing errors, and more.