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News September 12, 2005 Issue

Fund Adviser Sued For Principal Trades in Foreign Exchange

Can you do principal trades in FX?

You can if you are simply an adviser: Section 206(3) prohibits principal trades in "securities," and foreign exchange is not a security (of course, you should still consider general anti-fraud and disclosure issues).

But if thereís an investment company or ERISA account in the picture, you canít, no how, no way (at least absent a specific exemption): ICA Section 17(a) prohibits affiliated principal trades in "any security or other property" from a fund. ERISA contains a similarly broad prohibition.

Thatís a distinction that seems to have slipped by the compliance professionals at Minneapolis, Minnesota-based U.S. Bank National Association. Itís not hard to see why: according to the SECís September 2 order against the bank, from 1994 to 1995, there was no one in charge of compliance for the bankís asset management division. Then, for the next three years, there was no one with securities compliance experience. It wasnít until 1998 that the compliance staff had securities training.

All the while, the bankís foreign exchange department had been engaging in prohibited principal transactions with mutual funds advised by the bank. Unfortunately for the bank, the issue was not spotted until after it had merged with another company.

According to the SEC, examiners had raised concerns about the bankís procedures for complying with the ICA transaction restrictions not once, but twice, in examination deficiency letters. Apparently after the bank received the second letter, the funds' sub-adviser began submitting quarterly transaction reports to the bank reporting any affiliated principal transactions engaged in by the funds. However, the sub-adviser did not disclose the foreign exchange transactions on the reports. And, according to the SEC, the head of the bankís compliance group responsible for checking the accuracy of the reports was only trained in banking regs. "As a result," said the SEC, "she did not know that the foreign exchange transactions were prohibited and thought that the reports only required disclosure of affiliated principal securities transactions."

The SEC made a point of alleging that the bank did not adequately staff its compliance department with individuals knowledgeable in the area of securities regulation, and did not provide its employees with training that adequately addressed affiliated transactions prohibited under the Investment Company Act.

When the issue was discovered, the bank retained an outside law firm to investigate and report to the board. A public accounting firm retained by the bank estimated that the funds might have paid $636,338 in excess of the Bloomberg high/low composite prices for the relevant foreign currency transactions.

To settle the case, U.S. Bank agreed to pay a $500,000 civil money penalty. It also agreed to form a risk committee and hire a consultant to review the bankís Section 17(a) procedures.