Investment Advisers Act of 1940
Release No. 2070 / October 25, 2002
Investment Company Act of 1940
Release No. 25787 / October 25, 2002
Administrative Proceeding
File No. 3-10920
In the Matter of BACK BAY ADVISORS, L.P. Respondent. |
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ORDER INSTITUTING ADMINISTRATIVE PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and hereby are, instituted pursuant to Section 203(e) of the Investment Advisers Act of 1940 ("Advisers Act") and Section 9(b) of the Investment Company Act of 1940 ("Investment Company Act") against Back Bay Advisors, L.P. ("Back Bay").
II.
In anticipation of the institution of these administrative proceedings, Back Bay has submitted an Offer of Settlement (the "Offer") which the Commission has determined to accept. Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over it and the subject matter of these proceedings, which are admitted, Back Bay consents to the issuance of this Order Instituting Administrative Proceedings, Making Findings, and Imposing Remedial Sanctions ("Order"), as set forth below.
III.
On the basis of this Order and Back Bay's Offer of Settlement, the Commission finds that:1
A. Respondent
Back Bay was, at all relevant times, registered with the Commission as an investment adviser pursuant to Section 203(c) of the Advisers Act (File No. 801-27694) with its principal place of business in Boston, Massachusetts. In December 1999, the firm had approximately $5 billion under management. At all relevant times, the firm invested in fixed income securities on behalf of insurance company portfolios and pension and retirement plans, among others. Back Bay originated in 1986 as a subsidiary of The New England Mutual Life Insurance Company ("The New England"). In 1996, Metropolitan Life Insurance Company ("MetLife") acquired The New England. As of August 1996 and at all relevant times thereafter, Back Bay was a wholly-owned subsidiary of Nvest Companies L.P. ("Nvest"), whose managing general partner, Nvest Corporation, was an indirect wholly-owned subsidiary of MetLife. On June 29, 2001, Back Bay ceased managing assets and, on July 9, 2001, withdrew its registration by filing a Form ADV-W with the Commission.
B. Relevant Entity
Back Bay Total Return Bond Fund (the "Back Bay Bond Fund") was at all relevant times an open-end mutual fund created for institutional clients. The fund commenced sales on December 22, 1997 (File No. 811-8339) and was liquidated on June 29, 2001. Back Bay was the fund's adviser throughout the life of the fund.
C. Facts
1. Summary
This matter involves Back Bay Advisors, L.P., a registered investment adviser that engaged in violations with respect to prohibited affiliated transactions, including false statements or omissions to clients, alteration of records, and record keeping requirements. Back Bay also failed reasonably to supervise employees with a view toward preventing violations of the federal securities laws. Between 1994 and 1999, Back Bay effected certain trades between its clients -- known as "cross trades" -- in violation of Sections 17(a)(1) and (2) of the Investment Company Act, which generally prohibit any affiliated person of a registered investment company, or any affiliated person of such affiliated person, acting as principal, from engaging in transactions with the registered investment company. Back Bay's violative affiliated transactionsconsisted of: (i) cross trades between an investment company client and an account of Back Bay's indirect parent; and (ii) cross trades between Back Bay's investment company clients. Back Bay also made multiple false statements and omissions to clients about those affiliated transactions largely because its internal records did not properly reflect their existence. Back Bay also willfully violated the record keeping provisions of the Investment Company Act and Advisers Act when, shortly before the Commission's regulation staff came on-site to conduct a routine examination in early December 1999, the firm's chief investment officer (the "CIO") told a Back Bay trader to add information to the firm's completed cross trade tickets that would reflect "competitive levels," that is, market bid and ask prices cited by dealers that Back Bay obtained when canvassing the market. The trader thereupon wrote prices on the tickets that reflected merely an estimate of what the competitive levels were at the time of the trades. This rendered these tickets materially inaccurate by implying that the levels had actually been obtained while Back Bay canvassed the market when in fact they were not. Back Bay's violations occurred in part because the firm failed to develop an adequate supervisory system as it increased its business. Accordingly, Back Bay willfully violated Sections 204, 206(1), and 206(2) of the Advisers Act and Rule 204-2(a)(3) thereunder and Section 34(a) of the Investment Company Act and willfully aided and abetted violations of Sections 17(a) and 34(b) of the Investment Company Act. Back Bay also failed reasonably to supervise, within the meaning of Section 203(e)(6) of the Advisers Act, with a view toward preventing employees' violations of the federal securities laws.
2. Background
From its inception in 1986 through 1999, Back Bay managed portfolios on behalf of the insurance companies with which it was affiliated, initially The New England and, beginning in 1996, MetLife. Between 1997 and 1999, Back Bay managed three accounts on behalf of MetLife (the "MetLife Accounts") under the CIO's oversight. Back Bay also served as subadviser to two families of retail mutual funds (collectively, the "New England Retail Funds"). In the mid-1990s, Back Bay began expanding its client base by marketing itself to institutional investors such as corporate retirement accounts. By the fall of 1999, Back Bay's institutional assets under management exceeded $2 billion. The Back Bay Bond Fund, an institutional mutual fund which the firm created and launched in late 1997, was managed by a portfolio manager under the oversight of the CIO.
3. Violative Cross Trades
Between 1994 and 1999, Back Bay effected two types of violative affiliated transactions. First, Back Bay effected 65 transactions between the MetLife Accounts on one hand and the adviser's investment company clients on the other, most frequently the Back Bay Bond Fund. Second, Back Bay effected numerous cross trades between its investment company clients.
As discussed in the Legal Analysis below, Sections 17(a)(1) and (2) of the Investment Company Act prohibit any affiliated person, or promoter of, or principal underwriter for aregistered investment company, or any affiliated person of such affiliated person, promoter, or principal underwriter, acting as principal, from engaging in certain transactions with such registered investment company, unless the Commission grants an order under Section 17(b) of the Investment Company Act exempting the transaction from the provisions of Section 17(a).2 Rule 17a-7 exempts from the prohibitions of Sections 17(a)(1) and (2) a purchase or sale transaction between: (i) two registered investment companies, or (ii) "a registered investment company and a person [that] is an affiliated person of such registered investment company (or affiliated person of such person) solely by reason of having a common investment adviser or investment advisers that are affiliated persons of each other, common directors, and/or common officers."3 The exemption provided by the rule is subject to certain conditions, set forth in the rule, intended to ensure that the exempted transaction is fair to both parties.
Back Bay's personnel were ignorant of the applicable statutory requirements and instead followed their own practices for cross trading.4 They were generally unaware that, as discussed in the Legal Analysis below, cross trades between the MetLife Accounts on one hand and Back Bay's investment company clients on the other were altogether prohibited. Likewise, they wereunaware that cross trades between the adviser's investment company clients violated Sections 17(a)(1) and (2) unless the trades conformed to Rule 17a-7's specific provisions governing, among other things, price determination. Instead, to arrive at a price for its cross trades, Back Bay traders estimated the midpoint between the bids and the asks for a given bond based upon their knowledge of the market and general communications with brokers. With an estimated mid-market price in mind, the traders engaged a broker and dictated the price at which the cross trade was to be executed. The prices Back Bay obtained for its clients using its method therefore differed from those which the firm would have arrived at under Rule 17a-7. Further, as part of the process, Back Bay paid an incremental markup for the broker's services, thereby failing to conform to the requirements of Rule 17a-7, which is available only when a brokerage fee (except a customary transfer fee) or other remuneration is not charged. By not following Rule 17a-7, Back Bay caused cross trades between its investment company clients to be effected at prices other than the prices mandated by the rule. If the firm had followed Rule 17a-7, no fees would have been paid. The gross improper costs and expenses incurred by Back Bay's clients for the transactions that could have qualified for Rule 17a-7's exemption was over $200,000.5
Back Bay's cross trading violations occurred in part because of its poor compliance controls. The firm's practice for detecting Rule 17a-7 transactions consisted of distributing quarterly compliance forms to portfolio managers on which they were required to indicate with a check mark whether their funds had engaged in any Rule 17a-7 transactions in the preceding quarter. Back Bay never trained its CIO, compliance officer, portfolio managers or any of its other personnel about affiliated transactions. The closest the firm came to educating employees was its practice of periodically distributing a compliance guide to some of its investment staff. However, Back Bay took no efforts to ensure that its staff actually consulted the manual. Some personnel, including the CIO, could not recall ever referring to it. The firm incorrectly assumed that its personnel were familiar with the relevant rules. The portfolio managers who effected cross trades repeatedly indicated on the quarterly compliance questionnaires that no such transactions had occurred. Back Bay had no policies or procedures in place to test the accuracy of those responses. As a result, Back Bay never caught any of the errors and they persisted for years.
4. Back Bay's False Statements and Omissions to Clients Concerning Cross Trading
Back Bay failed to disclose to its investment company clients its practice of cross trading between affiliates because Back Bay's employees misunderstood the relevant statutory provisions and did not report that such trades had occurred. Those clients (the New England Retail Funds and the Back Bay Bond Fund) had each furnished Back Bay with procedures by which Back Baywas supposed to effect Rule 17a-7 transactions. These procedures tracked the language of Rule 17a-7 itself and expressly required Back Bay to report Rule 17a-7 transactions to its investment company clients each quarter. For the New England Retail Funds, Back Bay's compliance officer handled the reporting process, which he did by repeating the information that portfolio managers had provided to him. Since the portfolio managers never identified any Rule 17a-7 transactions on the quarterly compliance reports, in the compliance officer's subsequent representations to the New England Retail Funds, he incorrectly stated that there were no Rule 17a-7 transactions to report. As for the Back Bay Bond Fund, the responsibility of reporting Rule 17a-7 transactions to the client rested with the CIO. The CIO periodically conferred with the secretary of the Fund but, on each occasion, failed to identify any affiliated or Rule 17a-7 transactions.
By virtue of Back Bay's false statements and omissions, the boards of each client investment company did not approve any such transactions or keep records of Rule 17a-7 transactions, which they must do to comply with Rule 17a-7. As a further consequence, Back Bay's investment company clients filed Forms N-SAR incorrectly stating that they did not engage in affiliated transactions.
5. Cross Trading Records
On November 24, 1999, the Commission's regulation staff informed Back Bay by letter of its intent to commence a routine exam in the first week of December 1999. Back Bay was provided with a list of records subject to examination, including documents related to the firm's cross trading. Back Bay distributed a copy of the list to the CIO, among others. As Back Bay and its counsel prepared for the exam, they realized that Back Bay had been effecting cross trades that were not compliant with Rule 17a-7's pricing method of averaging the highest bid and lowest offer. Back Bay and its counsel thereupon attempted to determine what prices the firm would have reached if it in fact had followed Rule 17a-7's specific pricing method.
On November 30, 1999, the CIO directed a trader to add information to the firm's completed cross trade tickets dating back to July 1998 (the same time period referenced by the Commission staff's letter to Back Bay). Specifically, he directed the trader to place "competitive levels" on the tickets, i.e., prices that dealers offered to either buy or sell the bonds that Back Bay had cross traded. In carrying out the task, the trader obtained the firm's original trade tickets and began reviewing them. The trader reviewed trade tickets covering the period October through December 1998 and added competitive levels to ten order tickets concerning cross trades. The prices the trader added, however, were simply estimates of what the competitive levels were on the dates of the trades, based on a working knowledge of the industry and the trader's memory of where those bonds had been trading. The prices the trader added had not actually been obtained by the firm when canvassing the market. The trader stopped doing the task after a portfolio manager advised that writing on original trade tickets was improper. Subsequently, the trader brought the matter to the attention of the firm's CEO, who immediately contacted counsel. Shortly thereafter, Back Bay notified the Commission's regulation staff of the matter.
D. Legal Analysis
1. Affiliated Transactions in Violation of Sections 17(a)(1) and (2) of the Investment Company Act Arising Out of Cross Trades
Sections 17(a)(1) and (2) of the Investment Company Act prohibit an affiliated person of a registered investment company, or an affiliated person of such affiliated person, acting as principal, from knowingly selling a security to, or purchasing a security from, the investment company, unless the Commission grants an order under Section 17(b) of the Investment Company Act exempting the transaction from the provisions of Section 17(a). However, Rule 17a-7 sets forth an exemption to Section 17(a)'s general prohibition. To be eligible for the Rule 17a-7 exemption, the transaction must be between two registered investment companies or between an investment company and a person that is an affiliated person of such investment company (or affiliated person of such person) solely by reason of having a common investment adviser. A condition of that exemption is that the trade must be effected at the "current market price," which, for most bonds, is defined as the average of the highest current independent bid and lowest current independent offer determined on the basis of reasonable inquiry. See Rule 17a-7(b)(4). No brokerage commission, fee (except customary transfer fees) or other remuneration may be paid in connection with the transaction. See Rule 17a-7(d). To meet Rule 17a-7's exemption, the board of directors of any investment company involved in the trade must adopt procedures for eligible affiliated transactions and determine at least quarterly that all such transactions complied with those procedures. See Rule 17a-7(e). The investment company is also required to keep records of the terms of all Rule 17a-7 transactions. See Rule 17a-7(g).6
In the present case, the violations of Section 17(a)(1) and (2) fall into two general categories: (1) affiliated transactions that were ineligible for Rule 17a-7 altogether, and (2) transactions that may have been exempt from the statutory prohibitions if Back Bay had complied with Rule 17a-7's conditions, but were not exempt because Back Bay failed to execute the trades in accordance with the rule. The first category consists of cross trades between the accounts of Back Bay's indirect parent, MetLife, and various Back Bay investment company clients. MetLife's control of Back Bay made it an affiliated person of Back Bay and an affiliated person of an affiliated person with respect to Back Bay's registered investment company clients. Since Rule 17a-7's exemption only applies where the affiliation between the trading parties is based solely on having a common investment adviser, the cross trades between the MetLife Accounts and Back Bay's investment company clients were altogether ineligible for Rule 17a-7's exemption and therefore violated Sections 17(a)(1) and (2).
The second category of transactions that violated Sections 17(a)(1) and (2) consists of all of Back Bay's other cross trades between investment companies advised by Back Bay. For these cross trades, the trading parties were affiliated solely by having a common investment adviserand therefore could have been exempt under Rule 17a-7 if Back Bay had followed the provisions of the rule. However, in each instance, Back Bay failed to adhere the transactions to the provisions of Rule 17a-7. Significantly, for each of these cross trades, Back Bay did not execute trades at the "current market price" because its traders did not use the average between the highest current bid and lowest current offer determined on the basis of reasonable inquiry. Instead, Back Bay estimated midmarket prices, without regard to the requirements of Rule 17a-7. In addition, Back Bay paid brokerage markups in connection with a majority of these cross trades, in contravention of the Rule 17a-7(d) requirement that no brokerage fee or other remuneration may be paid in connection with the transaction. These cross trade violations caused over $200,000 in gross improper costs and expenses to clients. Further, certain of Back Bay's investment company clients failed to keep records of cross trading as required by then-Rule 17a-7(f) (now Rule 17a-7(g)) because Back Bay failed to inform them of the cross trades. Finally, the boards of those investment companies (which were also not informed about the cross trading) did not determine that the Rule 17a-7 transactions were effected in accordance with the boards' procedures, as required by Rule 17a-7(e).
Based on the two above-described categories of cross trades, Back Bay willfully aided and abetted violations of Sections 17(a)(1) and (2) of the Investment Company Act.7 See Strong/Corneliuson Capital Management, Inc., Advisers Act Rel. No. 1425 (July 12, 1994), 1994 SEC LEXIS 2100 at *15 (investment adviser aided and abetted Section 17(a) violations where it effected cross trades that constituted primary violations of Section 17(a)) (settled proceeding). To establish aiding and abetting liability, the Commission must show: (1) a primary securities law violation, (2) that the aider and abettor knowingly and substantially assisted the conduct that constitutes the violation, and (3) awareness or knowledge by the aider and abettor that his or her role was part of an overall activity that was improper. See Investors Research Corp. v. SEC, 628 F.2d 168, 178 (D.C. Cir. 1980), cert. denied, 449 U.S. 919; Woods v. Barnett Bank, 765 F.2d 1004, 1009 (11th Cir. 1985).
As applied to Back Bay, each of the three elements of aiding and abetting liability is met. First, as discussed above, there were primary violations of Sections 17(a)(1) and (2). Second, Back Bay substantially assisted in the violative conduct as the investment adviser that directed all of the cross trades at issue. Finally, the requisite state of mind is established. Back Bay was a fiduciary to its clients and was required to act in the clients' best interests. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963). Where the aider and abettor is a fiduciary of the harmed party, recklessness is sufficient to establish scienter. See IIT v. Cornfeld, 619 F.2d 909, 923-925 (2d Cir. 1980); Ross v. Bolton, 904 F.2d 819, 824 (2d Cir. 1990). Back Bay, through its CIO, knew or was reckless in not knowing that the cross trades it effected were improper. Nonetheless, he approved such cross trades. When he was consulted on the veryquestion of Rule 17a-7's applicability, he failed to give the matter sufficient review to ensure that his interpretation of the rule was correct. In fact, it was not, which led to still further violative cross trades. Accordingly, Back Bay willfully aided and abetted violations of Sections 17(a)(1) and (2) of the Investment Company Act.
2. False Statements to Clients Concerning Affiliated Transactions
a. Back Bay Willfully Violated Sections 206(1) and (2) of the Advisers Act
Section 206(1) of the Advisers Act makes it unlawful for any investment adviser to employ any device, scheme, or artifice to defraud any client or prospective client. Under Section 206(2) of the Advisers Act, it is unlawful for any investment adviser to employ any device, scheme or artifice to defraud, or to engage in any act, transaction, practice, or course of business which operates as a fraud or deceit on any client or prospective client. Scienter is an element of a claim under Section 206(1) but not Section 206(2). See SEC v. Steadman, 967 F.2d 641, 643 & n.5 (D.C. Cir. 1992). The scienter element of Section 206(1) may be satisfied by a showing that the investment adviser was reckless. Id. at 641-42.
Back Bay willfully violated Sections 206(1) and (2), through its acts and omissions, by failing to inform its mutual fund clients about the affiliated transactions it had caused those clients to engage in. In view of the multiple affiliated transactions that occurred, Back Bay's statements and omissions were misleading. Back Bay, through its compliance officer and CIO, knew or was reckless in not knowing that its statements and omissions were false and misleading. The compliance officer and CIO were each responsible for providing clients accurate information about affiliated transactions and they failed to do so. Moreover, these violations could have been avoided if the firm had employed adequate compliance controls regarding affiliated transactions, including educating its personnel or testing the self-reporting of its portfolio managers. It did not do so. Accordingly, Back Bay willfully violated Sections 206(1) and (2) of the Advisers Act.
b. Back Bay Willfully Aided and Abetted Violations of Section 34(b) of the Investment Company Act.
Back Bay willfully aided and abetted violations of Section 34(b) of the Investment Company Act in connection with its clients' filings of false Forms N-SAR. Section 34(b) provides that "[i]t shall be unlawful for any person to make any untrue statement of a material fact in any registration statement, application, report, account, record, or other document" that is required to be filed or maintained. The three elements of aiding and abetting -- a primary violation, substantial assistance, and recklessness -- are all present. First, there were underlying primary violations of Section 34(b), as Back Bay's mutual fund clients filed Forms N-SAR claiming (incorrectly) that they did not engage in affiliated transactions. See Strong/Corneliuson, 1994 SEC LEXIS 2100 at *18 (finding liability under Section 34(b) for false statements in FormN-SAR which stated that the fund did not engage in affiliated transactions) (settled proceeding). Second, Back Bay substantially assisted in those primary violations by serving as the source of the misinformation. Finally, as discussed above, Back Bay had the requisite state of mind. For those reasons, Back Bay willfully aided and abetted the underlying primary violations of Section 34(b).
3. Trade Ticket Alterations
Through the alterations of trade order tickets at the CIO's instruction, Back Bay is liable for violations of the Advisers Act and the Investment Company Act.
a. Back Bay Willfully Violated Section 204 of the Advisers Act and Rule 204-2(a)(3)
By virtue of its inaccurate trade tickets, Back Bay willfully violated Section 204 of the Advisers Act and Rule 204-2(a)(3) thereunder, which requires investment advisers to keep accurate records concerning trading. See Scudder Kemper Investments, Inc. and Gary Paul Johnson, Advisers Act Rel. No. 1848 (Dec. 22, 1999), 1999 SEC LEXIS 2737 at *17 (adviser liable under Section 204 where trader failed to submit order tickets and forged others) (settled proceeding).
b. Back Bay Willfully Violated Section 34(a) of the Investment Company Act.
Section 34(a) of the Investment Company Act, which provides in relevant part:
It shall be unlawful for any person, except as permitted by rule, regulation, or order of the Commission, willfully to destroy, mutilate, or alter any . . . document the preservation of which has been required pursuant to section 31(a) or 32(c).
Through the CIO's direction to the trader to alter order tickets, Back Bay willfully violated Section 34(a).
4. Failure to Supervise
Section 203(e) of the Advisers Act authorizes the Commission to impose sanctions against an investment adviser if the adviser fails reasonably to supervise, with a view to preventing violations of the securities laws, another person who commits such a violation, if that person is subject to the adviser's supervision. "The Commission has repeatedly emphasized that the duty to supervise is a critical component of the federal regulatory scheme." Rhumbline Advisers, Advisers Act Rel. No. 1765 (Sept. 29, 1998), 1998 SEC LEXIS 2117 at *10 (settled proceeding) (citing John H. Gutfreund, Exchange Act Rel. No. 31554 (Dec. 3, 1992), 1992 SECLEXIS 2939 at *34. An investment adviser must have in place supervisory procedures adequate to detect and prevent violations by its associated persons. Vilis Pasts, BTS/Bond Timing, Inc, Advisers Act Rel. No. 1663 (Sept. 15, 1997), 1997 SEC LEXIS 1903 at *17 (adviser had inadequate supervisory procedures to detect and prevent violations) (settled proceeding).
Back Bay failed reasonably to supervise its investment staff who engaged in or aided and abetted multiple affiliated transactions in violation of Sections 17(a)(1) and (2) of the Investment Company Act. Back Bay did not have adequate procedures and policies in place to detect and prevent violations of the securities laws such as improper affiliated transactions. The firm relied heavily on self-reporting and self-monitoring by portfolio managers to determine whether the firm was in compliance with the federal securities laws. While Back Bay distributed procedural manuals to its employees that covered issues such as Rule 17a-7 transactions, it did not, for example, ensure that the employees actually read or understood the manuals. Moreover, the firm did not ensure that the firm's business was conducted in accordance with the securities laws. This inadequate system led to violations of Sections 17(a)(1) and (2) by the investment staff. See, e.g., Scudder Kemper Investments, Inc., 1999 SEC LEXIS 2737 at *12 (registrant failed to supervise where supervisory and monitoring system "relied too heavily on traders accurately to self-report and code transactions") (settled proceeding); M&I Investment Management Corp., Advisers Act Rel. No. 1318 (June 30, 1992), 1992 SEC LEXIS 1578 at *4 (sanctioning adviser that failed to have trade error procedures in place) (settled proceeding).8
E. Violations
By virtue of the above-described conduct, Back Bay willfully violated Sections 204, 206(1), and 206(2) of the Advisers Act and Rule 204-2(a)(3) thereunder and Section 34(a) of the Investment Company Act and willfully aided and abetted violations of Sections 17(a)(1) and (2) and 34(b) of the Investment Company Act. Back Bay also failed reasonably to supervise its personnel with a view to preventing their violations of Sections 17(a)(1) and (2) of the Investment Company Act, within the meaning of Section 203(e)(6) of the Advisers Act.
IV.
In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Back Bay and cooperation afforded the Commission staff.
V.
In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer submitted by Back Bay and impose the sanctions specified in Back Bay's Offer.
Accordingly, IT IS HEREBY ORDERED pursuant to Section 203(e) of the Advisers Act that Back Bay is censured.
IT IS FURTHER ORDERED that Back Bay shall, within ten days of the entry of this Order, pay a civil money penalty in the amount of $150,000 to the United States Treasury. Such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank money order; (B) made payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Alexandria, VA 22312-0003; and (D) submitted under cover letter that identifies Back Bay as a Respondent in these proceedings and the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Juan Marcel Marcelino, District Administrator, Securities and Exchange Commission, Boston District Office, 73 Tremont Street, Suite 600, Boston, Massachusetts 02108.
By the Commission.
Jonathan G. Katz
Secretary
Endnotes
1 The findings herein are not binding on anyone other than Back Bay.
2 Section 2(a)(3) of the Investment Company Act defines an "affiliated person" to include "(A) any person directly or indirectly owning, controlling, or holding with power to vote, 5 per centum or more of the outstanding voting securities of such other person; (B) any person 5 per centum or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person; (C) any person directly or indirectly controlling, controlled by, or under common control with, such other person; (D) any officer, director, partner, copartner, or employee of such other person; [and] (E) if such other person is an investment company, any investment adviser thereof or any member of an advisory board thereof . . . ." Section 2(a)(9) of the Investment Company Act defines "control" as the "power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company . . . . Any person who owns beneficially, either directly or through one or more controlled companies, more than 25 per centum of the voting securities of a company shall be presumed to control such company."
3 Rule 17a-7 also is available in other circumstances unrelated to this case.
4 In March 1998, before making his first cross trade, the portfolio manager of the Back Bay Bond Fund approached the CIO and asked him whether there were any rules or regulations governing such a transaction. The portfolio manager and CIO thereupon consulted an internal memorandum concerning Rule 17a-7. However, they incorrectly concluded that Back Bay could freely effect cross trades involving its clients so long as a broker was used in the transaction. Despite his position and responsibilities, the CIO took no steps to confer with Back Bay's CEO or with counsel to determine whether he and the portfolio manager understood the rule. He also could not recall ever referring to the firm's compliance guide, which contained information about Rule 17a-7 transactions. As a result, Back Bay went on to improperly effect many cross trades between affiliates.
5 Back Bay has already compensated its clients for those gross costs and expenses. To the extent a client realized a gain from an improper cross trade, Back Bay did not seek return of that gain. Back Bay also compensated clients in the amount of about $200,000 for the prohibited transactions involving the MetLife Accounts.
6 Rule 17a-7(g) was formerly Rule 17a-7(f).
7 Back Bay is charged with aiding and abetting - as opposed to directly violating Sections 17(a)(1) and (2) of the Investment Company Act - because Sections 17(a)(1) and (2) apply directly to the party that trades with the registered investment company, not the adviser that effects the trade.
8 Although failure to supervise violations frequently follow upon the existence of "red flags" that should have placed the firm and its management on notice of underlying problems, the presence or absence of red flags is not dispositive. As the Commission has recognized, the inadequacy of a firm's supervisory system may preclude the appearance of red flags. See William V. Giordano, Exchange Act Rel. No. 36742 (Jan. 19, 1996), 1996 SEC LEXIS 71, *12 n.4 (observing that absence of red flags "is not a defense where the gravamen of the supervisory deficiency is a failure to have reasonable procedures") (settled proceeding). See also NationsSecurities and Nationsbank, N.A., Exchange Act Rel. No. 39947 (May 4, 1998), 1998 SEC LEXIS 833 at *34 (same) (settled proceeding).