The U.S. Attorney’s Office (District of Connecticut) announced that it entered into a plea agreement with an owner/investment adviser representative of an investment adviser firm based in Connecticut. This CT investment adviser representative waived his right to be indicted and pled guilty to defrauding clients of $2.7 million through a cherry-picking scheme. Last month, the U.S. Securities and Exchange Commission (“SEC”) also issued a cease-and-desist order against this investment adviser representative and firm. This blog post will review the cherry-picking allegations and offer several best practices for a chief compliance officer (“CCO”) to detect such activity within his or her own investment adviser firm.
The Cherry-Picking Scheme
The following is a summary of key facts based upon the allegations of the U.S. Attorney’s Office and SEC. RIA Compliance Consultants, Inc. has not independently verified the accuracy of such allegations.
This Connecticut-based investment adviser firm’s Code of Ethics allegedly required CT investment adviser representative to determine and document the specific allocation of each block trade prior to the execution and to allocate block trades to individual accounts at an average price.
Additionally, the investment adviser firm’s Form ADV Part 2A disclosure brochure allegedly stated that the firm would execute trades based upon a client’s risk tolerance, make investment decisions in accordance with its fiduciary duty, allocate investment opportunities fairly and equitably and never allow its investment adviser representative to engage in personal trading that disadvantages a client when similar securities are being bought or sold.
However, the CT investment adviser representative allegedly entered block trades on behalf of multiple client accounts without also assigning (at the time of entering each order) a corresponding allocation to the applicable accounts. After observing whether the position from the executed block trade increased or decreased in value during the first day, the CT investment adviser representative allegedly allocated the more profitable trades to personal, family and favored client accounts and the unprofitable trades to other client accounts. The SEC found that the probability of this happening by chance was statistically nearly zero.
In the federal criminal case, the CT investment adviser representative is awaiting sentencing for the guilty plea to one count of securities fraud, which carries a maximum term of imprisonment of 25 years and a fine of up to approximately $5.4 million.
In announcing the settlement of the administrative proceeding, the Co-Chief of the SEC Enforcement Division’s Asset Management Unit made a veiled reference to its market surveillance capabilities: “The SEC has the means to identify investment advisers that abuse their position through cherry-picking….” Although not specifically referenced in its press release, the SEC has previously identified the advance data analytics work of its Market Abuse Unit’s Analysis and Detection Center with respect to insider trading and cherry picking cases.
Best Practices for CCOs to Detect Cherry-Picking
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.
- 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.
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/
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 releae and securities regulator’s order and is not offering any opinion whether the allegations made by the prosecutor or 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.