Regulatory Alert
In a recent cease-and-desist order, the U.S. Securities and Exchange Commission (“SEC”) censured and fined two investment adviser firms for allegedly failing to supervise “cherry-picking” practices by two of its investment adviser representatives (IARs).
Cherry-picking occurs when an investment adviser representative allocates profitable trades to their personal accounts or the firm’s proprietary accounts while assigning less favorable trades to client accounts.
This recent SEC enforcement action highlights the risks of deficient compliance policies and ineffective supervision. Below are key facts from this case, which serve as a cautionary example for investment adviser firms related to cherry-picking by their investment adviser representatives.
Background Facts
The two investment adviser representatives (“IARs”) were affiliated with the initial investment adviser firm. Upon the withdrawal of the registration of the first investment adviser firm, these two investment adviser representatives became associated with a subsequent investment adviser firm which was an affiliate of the initial investment adviser firm.
During the period in question at these two firms, the investment adviser representatives allegedly allocated profitable trades to their own accounts and unprofitable trades to client accounts, resulting in a statistically significant disparity. The SEC explained that this scheme involved observing stock price movements throughout the day before allocating trades to personal or client accounts.
The SEC claimed that the investment adviser representatives disproportionately allocated profitable trades to their personal accounts and disproportionately allocated unprofitable trades to their advisory clients. The SEC’s order stated that the difference between the personal and client account allocations of profitable trades and unprofitable trades by each representative is statistically significant, and the probability of these results occurring by chance is nearly zero.
Failure to Supervise
With respect to the initial investment adviser firm, the SEC noted that firm’s policies mandated pre-trade allocation but allowed representatives to place aggregated trades through personal accounts. The SEC alleged that the investment adviser representatives were allowed to use their personal accounts to place aggregated trades without first submitting pre-trade allocation statements and to move block trades from their personal accounts to client accounts without approval from the firm’s Compliance department. The SEC asserted that that the initial investment adviser firm failed to monitor the fairness of allocations of these aggregated trades or to assess whether including personal trades in the aggregated order “materially diminished” the benefits of aggregation to clients
The SEC stated that the subsequent investment adviser firm had policies and procedures in place concerning “block trading” that prohibited investment adviser representatives “… from engaging in any activity that may be deemed to advantage one client over another…” and required the firm to monitor the trading activity within clients’ accounts “…[i]n order to ensure that no client or group of clients is favored over another ….” The policies and procedures further required investment adviser representatives to place aggregated orders through certain internal systems which “do not allow modifications to order allocations after a trade has been placed, which further limits unfair order allocations.” The SEC concluded that the subsequent investment adviser firm failed to implement its policies and procedures concerning block trading by not requiring the investment adviser representatives to place aggregated orders through the aforementioned internal systems that would have flagged the cherry-picking activities.
Best Practices for CCOs to Detect Cherry-Picking
In light of this enforcement action, the following are examples of best practices for an investment adviser firm and its chief compliance officer to consider for purposes of detecting cherry-picking (i.e., allocating profitable block trades after execution to favored accounts) by its investment adviser representatives.
Fair Allocation Methodology: Establish a written block trade allocation methodology that is fair and equitable.
Personal Accounts: Prohibit investment adviser representatives from placing block trades in the investment adviser representative’s personal account and then transferring executed trades from the personal account to client accounts. Only permit block trading from accounts which are fully visible to the investment adviser firm.
Pre-Trade Disclosure: Require (prior to or at the time the order is entered into the trading system) written and time-stamped initial allocations for any block trade orders.
Daily Supervisory Review: Review allocation reports daily and investigate any exceptions.
Periodic Compliance Testing: Review a sampling of block trades to verify compliance with allocation procedures.
Monitor Profitable Market Movements: Scrutinize whether trades are allocated based on subsequent market movements, especially at the end of the trading day.
Scrutinize Personal Accounts: Pay attention to proprietary, personal/family, performance fee, and new investment company accounts for signs of cherry-picking.
(Please understand that this is not a comprehensive listing of the techniques for detecting cherry picking.)
Cherry-picking is a serious offense that undermines the integrity of the investment adviser and client relationship. An investment adviser firm’s CCO has a critical role in detecting and preventing such fraudulent activities. By implementing these and other best practices, a CCO can better safeguard both the firm and its investment advisory clients.
Resources
Trading – Checklist for Detecting Cherry Picking
Included with Annual Compliance Packages (Bronze, Silver, Gold, Platinum & Titanium) in our KnowledgeBase at https://www.ria-compliance-consultants.com/knowledge-base/trading-checklist-for-detecting-cherry-picking/
Available on a la carte basis in our online store at https://www.ria-compliance-consultants.com/product/investment-adviser-trading-cherry-picking/
Personal Securities Transactions – Checklist for Reviewing PSTs & Holdings
Included with Annual Compliance Packages (Bronze, Silver, Gold, Platinum & Titanium) in KnowledgeBase at https://www.ria-compliance-consultants.com/knowledge-base/personal-securities-transactions-checklist-for-reviewing-psts/
Available on a la carte basis in our online store at https://www.ria-compliance-consultants.com/product/personal-securities-transactions-checklist-for-reviewing-psts/
Related Posts
Investment Adviser Enters Guilty Plea for Alleged Cherry Picking Scheme (10/08/2023)
Cherry Picking – SEC Cease-and-Desist Proceeding (3/28/2018)
SEC Fines Investment Adviser Firm $300,000 for Failure to Prevent Cherry Picking (1/18/2017)
SEC Enforcement Action Alleges Cherry-Picking, Double-Dipping, and Fund Mismanagement (10/25/2016)
SEC Revokes Investment Adviser’s Registration Due to Improper Trade Allocations (6/25/2008)
Written Policies for Block Trades (7/25/2005)
Disclaimer
The information contained in this blog post is general in nature intended for educational purposes only and is not a comprehensive analysis of this topic. This is merely a summary and does not necessarily include all material facts from the proceeding or order. RIA Compliance Consultants, Inc. has not verified the accuracy of the prosecutor’s press release and securities regulator’s order and is not offering any opinion whether the allegations made by the securities regulator are accurate. This post is not intended to constitute compliance consulting advice or apply to any particular investment adviser firm’s specific situation. Please consult the applicable securities regulator’s order, rules and published guidance for more details about the topics referenced above. For more information about the limitations of this blog post and information on our website, please see our Disclosures webpage.
Posted by Bryan Hill
Labels: Cherry Pick, Personal Securities Transactions, SEC, Trade Allocation
Tagged: PST
