Allocating favorable trades consistently to certain accounts, while consistently allocating less favorable trades to other accounts is an unethical practice that will cause serious problems for Registered Investment Advisers (RIAs) and Chief Compliance Officers (CCOs). Cherry-picking is a breach of an RIA’s fiduciary duty. To combat cherry-picking, the Commission recently announced its fourth action related to an enforcement initiative led by several of the SEC’s regional offices and supported by the SEC’s Division of Economic and Risk Analysis, which utilizes sophisticated tools for analyzing trading data.
On February 21, 2018, the SEC filed a complaint against an Orange County-based RIA and its president for operating a cherry-picking scheme that defrauded the firm’s clients. The complaint alleged that that the president of the firm’s brother and former CCO ignored numerous red flags. Aside from ignoring obvious signs of cherry-picking, the CCO was a member of a family trust, which benefited from the scheme. The SEC’s Litigation Release can be found here.
The SEC’s complaint alleged that the RIA’s president traded securities in the firm’s omnibus account but delayed allocating the securities to specific client accounts until he saw how securities performed during the day. The president reaped substantial profits by allocating the profitable trades to himself, leaving unprofitable ones for clients. The firm’s clients suffered, because the RIA allocated losing trades to them.
In addition, the complaint alleged that the RIA and its president misrepresented their trading and allocation practices in the firm’s Form ADV. The RIA’s Form ADV falsely stated that all trades would be allocated in a manner consistent with pre-trade allocation statements. Furthermore, the RIA falsely claimed that the firm’s trading practices did not favor its own accounts.
According to the complaint, the CCO was responsible for ensuring that the firm complied with its trading policies and procedures, which prohibited cherry-picking. Instead of fulfilling those responsibilities, the CCO operated the RIA’s compliance program in an extremely reckless manner. The CCO did not conduct reviews nor did he monitor the firm’s trading practices to ensure they were fair and equitable. He essentially did nothing to ensure that the RIA’s trading policies and procedures were followed other than occasionally spot-checking trade paperwork.
On March 8, 2018, the SEC settled charges against a Texas-based RIA for defrauding clients through a cherry-picking scheme. The principal and sole owner of the firm agreed to be banned from the securities industry and to pay $715,000 to resolve the charges. The SEC’s order can be found here.
As a reminder, pre-trade and post-trade allocations should always be documented and reviewed for any deviations. Any deviations, reasons for the deviations, and applicable remedies should be documented in the RIA’s compliance records.
Lessons learned from this enforcement initiative
The lesson learned from this enforcement initiative is that an RIA should never wait for subsequent market movements before deciding how to allocate trades among clients. The firm should always adhere to its trading policies and procedures, as well as its fiduciary obligations. When an RIA engages in cherry-picking, the firm is putting its own interest ahead of the client’s. Cherry-picking is every bit as serious if an RIA allocates profitable trades to favored clients, such as those individuals and companies with large accounts.
CCOs must do much more than just give lip service to their oversight responsibilities. They must implement and enforce robust trading policies and procedures that are designed to prevent unethical allocation practices and other breaches of their firms’ fiduciary obligations.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.