Enforcement News: Cherry-Picking Scheme Back In The News

• Posted on: Dec 18 2024

By: Jeffrey M. Haber

Two weeks ago, this Blog wrote about an enforcement action involving an investment adviser’s former co-chief investment officer who had been charged with running a more than $600 million cherry-picking scheme (here). Today, this Blog examines another enforcement action involving a former investment adviser representative, charged with engaging in a fraudulent trade allocation scheme – i.e., cherry-picking scheme – wherein he benefitted himself in the amount of approximately $170,000.00 in net profits while causing his advisory clients to lose in the aggregate approximately $188,000.00.

According to the SEC, from at least June 2019 to mid-April 2022, defendant allegedly allocated profitable trades to his personal and wife’s accounts (together, the “Favored Accounts”), and unprofitable trades to the accounts of his other clients (the “Disfavored Accounts”). To carry out this scheme, defendant engaged in frequent “block trading” – a form of trading in which securities trade orders are placed in one aggregated account (e.g., an omnibus or master account), rather than directly in specific client accounts – and then waited at least one day after the trades were executed before allocating them between his client accounts on the one hand, and accounts held by him and his wife on the other hand.

By waiting to allocate, said the SEC, defendant could see whether the price of the securities he traded rose or fell after the trades were executed before deciding whether he would assign them to his accounts or to his clients’ accounts. At that point, noted the SEC, defendant disproportionately assigned the profitable trades to his account, and disproportionately allocated unprofitable trades to his clients’ accounts.[1]

Specifically, defendant allocated block trades for particular securities to the Favored Accounts on 286 occasions, with a dollar-weighted win rate of approximately 75%.[2]  But during that same period, defendant allocated block trades for particular securities to the Disfavored Accounts on 742 occasions, with a dollar-weighted win rate of approximately only 47%. Prior to receiving a warning from his advisory firm in May 2020, nearly all of defendant’s block trades—well over 90%—were allocated the following day. After receiving the warning, defendant continued to allocate some of his block trades the following day, although more allocations were done on the same day as the trades were executed.

The SEC alleged that the disproportionate allocations were not random, but rather reflected defendant’s knowing or reckless favoritism: the average return measured at the time of allocation for the Favored Accounts based on the foregoing was approximately 4.7%. In comparison, the average return at the time of allocation for the Disfavored Accounts was approximately 0.1%. Thus, alleged the SEC, the likelihood that defendant would have earned these returns for the Favored Accounts without cherry-picking, with trade allocations determined by chance, was less than 1%.

The SEC alleged that defendant chose to concentrate his trading for his and his clients’ accounts in securities that maximized his opportunity to profit from his cherry-picking scheme: risky, volatile securities, such as leveraged exchange-traded funds (“Leveraged ETFs”) that sought to amplify the returns on underlying indices, as well as volatile, non-leveraged ETFs and other securities based on volatile commodities, such as precious metals and mining.[3] For example, said the SEC, the Leveraged ETFs frequently had rapid and large price movements within a trading day, or from one trading day to the next. By concentrating his trading strategy on those investments, alleged the SEC, defendant was able to take quick profits from large price movements (or avoid large losses) in these securities by waiting a day to allocate them.

The SEC maintained that this speculative investment strategy was unsuitable and against the best interests of certain of defendant’s clients, whose financial profile, investment objectives and risk tolerance called for a far more conservative investment strategy.

The SEC also brought proceedings against SeaCrest Wealth Management, LLC (“SeaCrest” or “Respondent”), a New York-based investment adviser registered with the Commission, which oversees representatives located in more than two dozen offices around the country. According to the SEC, defendant was a representative of SeaCrest during the period of alleged wrongdoing.

The SEC claimed that SeaCrest failed to implement policies and procedures reasonably designed to prevent violations of the federal securities laws, and it failed reasonably to supervise defendant. In addition, the SEC alleged that SeaCrest’s Form ADV brochures negligently included statements about its practices and procedures that were false or misleading in light of SeaCrest’s compliance and supervision failures.

Without admitting or denying the SEC’s findings, SeaCrest agreed to settle the charges asserted against it. In that regard, SeaCrest agreed to (a) censure; (b) cease and desist from committing or causing any violations and any future violations of Section 17(a)(2) of the Securities Act of 1933, and Sections 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 promulgated thereunder; and (c) pay civil penalties of $375,000.00.[4] A copy of the cease-and-desist order can be found here.

The SEC filed the complaint (here) against defendant in United States District Court for the Southern District of New York. The SEC charged defendant with violating the antifraud provisions of the federal securities laws and seeks a permanent injunction, a conduct-based injunction, civil monetary penalties, disgorgement, and prejudgment interest.

The SEC announced the charges against defendant and the settlement with SeaCrest on December 12, 2024 (here).

Takeaway

It is common for investment managers to use an omnibus account for customer accounts and then purchase or sell for the accounts at the same time in a block trade. After execution, the investment advisor must allocate the block into the constituent client accounts.[5]

Because prices fluctuate throughout the day, an investment advisor can determine if the trade is a profit or loss, usually at the end of the day.[6] Armed with such information, an unscrupulous advisor will cherry pick winning or losing trades and allocate them in a preferential manner to favored accounts, such as their own personal accounts, at the expense of disfavored accounts.

The enforcement action and settlement discussed above – as well as others (e.g., here, here, and here) – shows the SEC’s continued vigilance in protecting investors from fraudulent allocation schemes.

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Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. This article is for informational purposes and is not intended to be and should not be taken as legal advice.

[1] According to the SEC, most of the transactions allocated to Favored Accounts approximated $43 million, while only a fraction of the money (approximately $9 million) was directed into Disfavored Accounts.

[2] A dollar-weighted win or loss rate takes into consideration the amount of the investment. The calculation is: total money invested in winning trades/total money invested.

[3] Leveraged ETFs are riskier than traditional ETFs in that they seek to deliver multiples of the short-term performance (e.g., daily) of the index or benchmark they track. FINRA Regulatory Notice 09-31 (here), published in June 2009, warned that leveraged ETFs “are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis” and that they “are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

[4] In agreeing to settle, the SEC considered the voluntary remedial acts undertaken by SeaCrest and SeaCrest’s voluntary cooperation with the SEC staff in its investigation of the matter.

[5] Trade allocation is commonly performed electronically through order management systems (OMSs), which are designed to make the process more efficient and fair, and prevent errors.

[6] The way to prevent cherry-picking is to determine the allocation before the trade is executed and not change it afterward to benefit certain accounts to the detriment of others.