by T. GormanPosted on Posted in SECActions

The SEC filed another action based on its market access rule. This time the Respondent is Goldman, Sachs & Co., a wholly owned subsidiary of The Goldman Sachs Group, Inc. In the Matter of Goldman, Sachs & Co., Adm. Proc. File No. 3-16665 (June 30, 2015).

The action centers on erroneously sending 16,000 mispriced options orders to various option exchanges in less than an hour on August 20, 2013. Respondent Goldman is a registered broker dealer and a member of FINRA. One of the client service functions performed by the firm is the provision of options liquidity to electronic trading customers. This service was done in part through the use of a matching engine that attempts to pair the firm’s indications of interest against customer orders for the particular option contract. If there was a match the paired order was sent to an exchange for execution. If there was no match the customer order was routed to an exchange. The firm’s indications of interest, called axes, were contingent in price, size and other parameters. They were not intended to go to the exchanges unless paired with a customer order. To the contrary, axes were intended to remain in the matching engine and search for customer orders to pair-off.

On August 20, 2013, as a result of a configuration error in one of the firm’s options order routers, Goldman sent thousands of $1 limit orders to options exchanges prior to the start of regular market trading. Before the market opened the firm halted the creation of orders and began canceling the erroneous ones that had been sent for execution.

Shortly after the opening a portion of the orders were executed. Specifically, about 1.5 million options contracts representing 150 million underlying shares were executed. Goldman faced a potential $500 million loss, although in the end it was about $38 million in view of cancellations or price adjustments for erroneous trades.

The error resulted from a series of failures, according to the Order, which included:

  • The price checks in the options order matching system failed to prevent the entry of the erroneously priced pre-market orders;
  • Goldman’s circuit breakers did not effectively block the orders because its control staff repeatedly lifted them during the pre-market and for two minutes after the open;
  • The firm’s policies relating to the manual lifting of the circuit breakers were not disseminated to, or fully understood by, the responsible employees; and
  • The firm had inadequate policies and procedures with regard to software changes that impacted its order flow.

Goldman also had inadequate risk management controls and supervisory procedures relating to the prevention of orders that exceeded the firm’s pre-set capital threshold. The Order alleges Exchange Act Section 15(c)(3) and Rule 15c-3-5.

To resolve the proceeding Goldman consented to the entry of a cease and desist order based on the Section and Rule cited in the Order as well as to a censure. In addition, the firm agreed to pay a civil penalty of $7 million.

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by T. GormanPosted on Posted in SECActions

The SEC filed its first action involving a private equity fund and broken deal expenses. By the time the Commission discovered the question the firm realized it did not have a disclosure policy, retained a consultant to study the issue and adopted a policy. Nevertheless, to settle the proceeding the firm was required to pay disgorgement and a $10 million penalty. In the Matter of Kohlberg Kravis Robert & Co. L.P.¸Adm. Proc. File No. 3-16656 (June 29, 2015).

Respondent KKR is a private equity firm specializing in buyout and other transactions. For its Flagship PE Funds and other advisory clients the firm advises and sources potential investments. The firm also provides investment management and administrative services to its private equity funds for a management fee. In addition, the firm raises capital from co-investors for its private equity transactions.

KKR incurs significant investment expenses sourcing investment opportunities. The firm is reimbursed directly from portfolio companies for expenses incurred with successful transactions. For broken deal expenses it is reimbursed through fee sharing arrangements with its funds. Consistent with the applicable limited partnership agreements, and those for the Flagship 2006 Fund LPA, KKR shared a portion of its monitoring, transaction and break-up fess with the 2006 Fund. Under the fee sharing arrangement KKR received 20% of the fees and economically bore 20% of the broken deal expenses. However, the 2006 Fund’s LPA and offering materials did not include any express disclosure that KKR did not allocate broken deal expenses to its co-investors despite the fact that they participated in, and benefited from, KKR’s general sourcing transactions.

From 2006 through 2011 KKR allocated broken deal expenses by geographic region where the potential deal was sourced. Thus it allocated broken deal expenses related to potential North American investments to the 2006 Fund. Before 2011 however the firm did not allocate or attribute any of those expenses to co-investors.

In June 2011 KKR concluded that it lacked a written policy governing its broken deal expenses. Over the next few months a policy was drafted, memorializing its allocation methodology. At the same time the firm decided to make an allocation of broken deal expenses to co-investment vehicles.

In late October 2011 KKR engaged a third party consultant to review the its fund expense allocation practice. Effective January 1, 2012 the firm revised its broken deal expense allocation methodology following the consultant’s review. A new methodology was implemented which allocated part of the expenses to partner vehicles and other co-investors.

In 2013 OCIE conducted a compliance exam which included a review of expense allocations. During the examination KKR refunded its Flagship PE Funds a total of $3.26 million in certain broken deal expenses that had been allocated to them from 2009 to 2011.

Prior to the institution of the new policy KKR did not allocate any share of broken deal expenses to its co-investors, with certain exceptions. Likewise, the firm did not expressly disclose in the LPAs or related materials that it did not allocate or attribute broken deal expenses to co-investors. As a result KKR misallocated $17.4 million in broken deal expenses between its Flagship PE Funds and co-investors, thereby breaching its fiduciary duty as an investment adviser, according to the Order. The Order alleges violations of Advisers Act Sections 206(2) and 206(4)-7.

Respondent resolved the matter, consenting to the entry of a cease and desist order based on the Sections cited in the Order. In addition, they agreed to pay disgorgement of $14,165,968 (net broken deal expenses), prejudgment interest and a penalty of $10 million.

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