United States of America
In the Matter of
EDGAR M. REED
|ORDER INSTITUTING ADMINISTRATIVE AND CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS AND A CEASE- AND-DESIST ORDER PURSUANT TO SECTIONS 203(f) AND 203(k) OF THE INVESTMENT ADVISERS ACT OF 1940 AND SECTIONS 9(b) AND 9(f) OF THE INVESTMENT COMPANY ACT OF 1940 AS TO EDGAR M. REED|
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Sections 203(f) and 203(k) of the Investment Advisers Act of 1940 ("Advisers Act") and Sections 9(b) and 9(f) of the Investment Company Act of 1940 ("Investment Company Act") against Edgar M. Reed ("Respondent").
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying thefindings herein, except as to the Commission's jurisdiction over him and the subject matter of these proceedings, Respondent consents to the entry of this Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions Pursuant to Sections 203(f) and 203(k) of the Investment Advisers Act of 1940 and Sections 9(b) and 9(f) of the Investment Company Act of 1940 ("Order"), as set forth below.
On the basis of this Order and Respondent's Offer, the Commission finds that:1
Edgar M. Reed, 55, was employed at Back Bay Advisors, L.P. ("Back Bay") from 1994 to 2001. At all relevant times, he was Back Bay's Chief Investment Officer ("CIO") and a Chartered Financial Analyst. Prior to joining Back Bay, Reed was the managing director of the fixed income department of an insurance company. He is a resident of West Hartford, Connecticut.
1. 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.
2. 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.
This matter involves violations of the Investment Company Act and the Investment Advisers Act by Reed. As CIO of Back Bay, Reed willfully aided and abetted and caused Back Bay's violations with respect to prohibited affiliated transactions, including misleading statements or omissions to clients, and record keeping. He also violated a provision of the Investment Company Act governing the alteration of records.
Between 1994 and 1999, Back Bay, under Reed, 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 transactions consisted 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, largely through Reed, also made multiple false statements and omissions to clients about those affiliated transactions. In addition, shortly before the Commission's regulation staff came on-site to conduct a routine examination in early December 1999, Reed 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 an estimate of what the competitive levels were at the time of the trades, but which were not reflective of price information that Back Bay had actually obtained when canvassing the market.
Accordingly, Reed willfully violated Section 34(a) of the Investment Company Act and willfully aided and abetted and caused violations of Sections 206(1), 206(2) and 204 of the Advisers Act and Rule 204-2(a)(3) thereunder and Sections 17(a) and 34(b) of the Investment Company Act.
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 Reed'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 Reed.
Among his responsibilities as CIO, Reed supervised Back Bay's portfolio managers and traders, with a particular emphasis on the staff dedicated to the institutional client base. As CIO, he was responsible for ensuring that his investment staff executed trades and managed portfolios in compliance with the securities laws. In addition, he was responsible for reporting to the secretary of the Back Bay Bond Fund on various compliance matters, including Rule 17a-7 transactions, which are discussed below.
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 a registered 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.
Reed and his investment staff 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 were unaware 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.
The Back Bay Bond Fund furnished Back Bay with procedures by which Back Bay was supposed to effect Rule 17a-7 transactions. Reed, however, did not adhere to them. The procedures tracked the language of Rule 17a-7 itself and expressly required Back Bay to report Rule 17a-7 transactions to the Fund each quarter. The responsibility of reporting Rule 17a-7 transactions to the Fund rested with Reed. Reed periodically conferred with the secretary of the Fund but, on each occasion, failed to identify any Rule 17a-7 transactions or disclose the prohibited affiliated transactions involving the Fund.
By virtue of Reed's failure to disclose affiliated transactions, the board of the Back BayBond Fund did not approve any such transactions or keep records of 17a-7 transactions, which it was required to do in order to comply with Rule 17a-7. As a further consequence, the Back Bay Bond Fund filed Forms N-SAR incorrectly stating that it did not engage in affiliated transactions.
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 Reed, among others. On December 1, 1999, 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, Reed 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 the trader's 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.
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, Rule17a-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).5
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 adviser and 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, Reed willfully aided and abetted and caused violations of Sections 17(a)(1) and (2) of the Investment Company Act.6 See Strong/Corneliuson Capital Management, Inc., Advisers Act Rel. No. 1425 (July 12, 1994), 1994 SEC LEXIS 2100 at *15 (individuals and investment adviser aided and abetted Section 17(a) violations where firm 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). 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). A finding that a person aided and abetted a violation will also establish that the person caused the violation. See Dominick & Dominick, Inc., Exchange Act Rel. No. 29243 n.11 (May 29, 1991), 1991 SEC LEXIS 1016 at *16 (settled proceeding).
As applied to Reed, 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, Reed substantially assisted in the violative conduct as the CIO who oversaw the firm's trading, including the violative cross trades. He approved individual cross trades and the general method by which Back Bay effected the cross trades. Finally, the requisite state of mind is established. Reed, an experienced securities professional who was responsible for ensuring that Back Bay's trades complied with the federal securities laws, knew or was reckless in not knowing that the cross trades effected by Back Bay violated Sections 17(a)(1) and (2). Reed was a fiduciary to Back Bay's 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). Nonetheless, he approved improper cross trades. When he was consulted on the very question of Rule 17a-7's applicability, he failed to give the matter sufficient review to ensure he understood the rule. In fact, he did not, which led to further violative cross trades.
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 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. Reed willfully aided and abetted and caused violations of Sections 206(1) and 206(2) by Back Bay. Reed was responsible for informing the Back Bay Bond Fund about affiliated transactions and he failed to disclose Back Bay's cross trading practices involving that fund. Reed knew or was reckless in not knowing that his failure to inform the Fund of affiliated transactions was improper. Accordingly, he is liable for willfully aiding and abetting and causing violations of Sections 206(1) and (2) of the Advisers Act.
Reed willfully aided and abetted and caused violations of Section 34(b) of the Investment Company Act in connection with Back Bay's 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 Form N-SAR which stated that the fund did not engage in affiliated transactions) (settled proceeding). Second, Reed substantially assisted in those primary violations by serving as a source of the misinformation. Finally, as discussed above, Reed had the requisite state of mind. For those reasons, Reed willfully aided and abetted and caused the underlying primary violations of Section 34(b).
By directing the trader to add information to trade order tickets shortly in advance of the Commission staff's examination, Reed willfully aided and abetted and caused Back Bay to violate Section 204 of the Advisers Act and Rule 204-2(a)(3), which require investment advisers to keep accurate records. 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). Reed knew or was reckless in not knowing that his actions violated these provisions. He ignored the necessity of preserving original records in their original form and subjected the records to the potential of being rendered inaccurate or misleading, which is what occurred.
For his role in the trade ticket matter, Reed also willfully violated Section 34(a) of the Investment Company Act. Section 34(a) 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).
By directing the trader to alter order tickets, Reed willfully violated Section 34(a).
By virtue of the above-described conduct, Reed willfully violated Section 34(a) of the Investment Company Act and willfully aided and abetted and caused violations of Sections 204, 206(1) and (2) of the Advisers Act and Rule 204-2(a)(3) thereunder and Sections 17(a) and 34(b) of the Investment Company Act.
Respondent undertakes to provide the Commission, within 30 days after the end of the 12 month suspension period described below, an affidavit that he has complied fully with the sanctions described in Section V. C. and D. below.
In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer submitted by Respondent and impose the sanctions specified in Respondent's Offer.
ACCORDINGLY, IT IS HEREBY ORDERED:
A. Pursuant to Section 203(f) of the Advisers Act that Respondent is censured.
B. Pursuant to Section 203(k) of the Advisers Act and Section 9(f) of the Investment Company Act that Respondent Reed cease and desist from committing or causing any violations and any future violations of Sections 17(a), 34(a) and 34(b) of the Investment Company Act and Sections 204, 206(1) and (2) of the Advisers Act and Rule 204-2(a)(3) thereunder.
C. Pursuant to Section 203(f) of the Advisers Act, Respondent be, and hereby is, suspended from association with any investment adviser for a period of 12 months, effective on the second Monday following the entry of this Order.
D. Pursuant to Section 9(b) of the Investment Company Act, Respondent is prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter for a period of 12 months, effective on the second Monday following the entry of this Order.
E. IT IS FURTHER ORDERED that Respondent shall, within thirty days of the entry of this Order, pay a civil money penalty in the amount of $25,000 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 Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (D) submitted under cover letter that identifies Reed 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.
F. Respondent shall comply with the undertakings described in Section IV above.
By the Commission.
Jonathan G. Katz
1 The findings herein are made pursuant to Respondent's Offer and are not binding on any other person or entity in this or any other proceeding.
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 Reed and asked him whether there were any rules or regulations governing such a transaction. The portfolio manager and Reed 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, Reed 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 Rule 17a-7(g) was formerly Rule 17a-7(f).
6 Reed 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.
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