Registered Investment Advisers (“RIAs”) owe a fiduciary duty to put their clients’ interests ahead of their own. When an RIA engages in cherry-picking, the firm is ripe to be sanctioned by securities regulators.
In most instances of cherry-picking, an RIA allocates trades unfairly. Typically, profitable trades are allocated to favored accounts. The RIA then allocates unprofitable trades to other accounts.
On April 19, 2016, the SEC settled an action brought against an Investment Adviser Representative (“IAR”) who engaged in cherry-picking. The IAR delayed allocation until after he had determined whether securities appreciated in value. Profitable trades were allocated to proprietary accounts. Unprofitable trades were allocated to clients’ accounts.
The SEC did the math and found that 85 percent of block trades allocated solely to proprietary accounts were profitable. Using data analysis, the SEC discovered that 100 percent of block trades allocated solely to the firm’s clients were unprofitable. Proprietary accounts averaged a first-day gain of 0.26 percent. In contrast, clients’ accounts averaged a first-day loss of 1.02 percent. Aside from engaging in cherry-picking, the RIA’s trade allocation policies were contrary to the firm’s Form ADV disclosures.
The SEC found that the IAR through his advisory firm willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. He also violated Sections 206(1) and 206(2) of the Investment Advisers Act. The action can be found athttps://www.sec.gov/litigation/admin/2016/34-77648.pdf.
In a second enforcement action brought on April 19, 2016, the SEC alleged that a California-based RIA was engaged in fraudulent trade allocations. The SEC found evidence that the firm was engaged in cherry-picking, even though the RIA’s Form ADV Part 2A said that the firm sought to allocate trade executions in the most equitable manner possible. In addition, the RIA’s policies and procedures stipulated that the firm would not give more favorable treatment when allocating trades to its own or affiliated accounts. Those policies and procedures also stated that the firm would not give more favorable treatment to selected accounts.
From January 2010 to August 2014, the RIA allegedly allocated a disproportionate number of profitable equity and options trades to favored clients. The clients that received preferential treatment were a lifelong family friend, a relative, and a few long-standing clients.
The SEC brought the enforcement action against the RIA, as well as the sole owner who also served as the firm’s Chief Compliance Officer. The third-party broker-dealer with custody of the firm’s accounts expressly warned the RIA at least five times about the improper trade allocations. The broker-dealer’s trade allocation surveillance system flagged the RIA on at least 21 occasions for suspicious trade allocations.
The SEC alleged that the RIA and its owner breached their fiduciary duty to clients and willfully violated Sections 206(1) and 206(2) of the Investment Advisers Act. The SEC also alleged that the firm and its owner violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
In addition, the SEC alleged that by making false statements in Form ADV Part 2A, the firm and its owner willfully violated Section 207 of the Investment Advisers Act. As an alternative argument, the SEC contended that the firm’s owner willfully aided and abetted and caused the RIA’s violations. The enforcement action can be found at https://www.sec.gov/litigation/admin/2016/34-77649.pdf.
The message from both of these enforcement actions is that RIAs should never wait for subsequent market movements before deciding how to allocate trades among accounts. RIAs should never play favorites when allocating trades.
Les Abromovitz can be reached at NCS Regulatory Compliance by calling 561-330-7645, Ext. 213, or by e-mailing him at labromovitz@ncsregcomp.com. Les is the author of THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE, which was published by the National Underwriter Company, a division of ALM. The book is available at http://www.nationalunderwriter.com/the-investment-advisor-s-compliance-guide-2.html.